Getting Out of Student Debt Using The Bankruptcy Code

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Credit: Alan Cleaver on Flikr

Shocking figures were released recently about student loans – outstanding dues across the country stand at around $1 trillion. Considering the poor state of the economy and job market, it is no surprise that these very loans which were created to help students advance in their academic and professional lives, become a burden and source of stress.

A few decades ago, it was possible for distressed graduates to declare bankruptcy and get a chance to start over, albeit with a crushed credit score. But from the lawmakers and lenders’ perspective, this relief tool was misused a tad too often. There were concerns that people who could afford to pay back their loans were ‘abusing’ the system and if permitted on a mass scale, this behavior could pose a threat to the financial sector.

The result was the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which made it very difficult to discharge one’s student debt under the US Bankruptcy Code. The new version of the code [§ 523(a)(8)] only allows student loans to be discharged after borrowers show evidence of ‘undue hardship’. Let’s not forget that once a student begins to fall back on loan installments, the interest rate is jacked up as a punitive measure, which makes it harder to pay back the loan.

Credit: Alan Cleaver on Flikr
Credit: Alan Cleaver on Flikr

Under the new law, you need to file an ‘adversary proceedings’ to prove you are one of those faced with ‘undue hardship’, which should not be a problem if your case is genuine. While the Bankruptcy Code stops short of defining ‘undue hardship’, there are three generally accepted guidelines that have determined the outcome of such cases in court. These are:

  • Being unable to maintain a minimum living standard if under the debt obligation,
  • There is a high probability that the above condition will remain for the majority of the loan term (this condition excludes students in lucrative career paths).
  • The borrower has tried a good deal to pay back the loan before filing for bankruptcy.

Next, you should hope that your student loan is fully forgiven, and even though your credit rating will fall dramatically after this, you still have a lot to celebrate about. However, if the judge only offers partial or no relief at all, it is not the end of the world. You can start making lifestyle choices to recover from the debt, such as setting up a household budget or looking for a second job to foot the bills.

There are other debt-relief options provided by the government, such as Pay-as-You-Earn and Income Based Repayment Plan (IBR), each one with unique benefits and drawbacks. For instance, under the IBR, your monthly installments are capped at 15% of your pay, but the program is only available to those who obtained student loans in 2012 or later. Let’s not forget, you often end up paying more interest under these programs because your loan repayment is stretched over a longer time period. Be sure to thoroughly research each option before you commit to these programs.

If none of the above offers sufficient help, perhaps you can find comfort in the fact that your loan will be fully forgiven by law after 25 years of repayment. Considering all this, student loans can potentially burden you and it is always wise to consider other debt-free ways to fund your college tuition.

Fehmeen is a financial writer who enjoys exploring different aspects of the debt-ridden economy in an attempt to help people make informed decisions. Any ideas shared in the article should merely be considered general information instead of financial advice.

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