Monday, December 10, 2012

Can a Student Discharge a Loan through Bankruptcy?

Can a student discharge a loan through bankruptcy?
The answer is (like everything in financial aid) somewhat complicated. In 9 out of 10 cases, the answer is no. But there is still that 1 case when it's possible. How? There are many ways, and it really depends on the state, the individual court, and the individual judge. However, what's stated here is the most often scenario.
Firstly, you have to look at the wording. In 2005, the exception to discharge was extended to include all education loans (private and federal). A debtor in Chapter 7 or Chapter 13 cannot discharge 1.) an educational loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution; or 2.) an obligation to repay funds received as an educational benefit (grants, scholarships); or 3.) any other educational loan that is a "qualified education loan" UNLESS excepting such debt from discharge under the above would impose an "undue hardship" on the debtor and the debtor's dependents.
That's the key: they have to prove "undue hardship", and that's rather difficult. So, what's the process?
1. The debtor files a bankruptcy petition (either Chapter 7 or 13).
2. The creditor then has to establish the existence of the debt and that it falls into one of the nondischargeable categories.
3. The debtor files an adversary proceeding and how to show an "undue hardship".
How does one prove "undue hardship"? The most often used test is called the Brunner Test. The Brunner Test is a 3-part test where the debtor has to prove all three of the following:
1.) That the debtor cannot maintain, based on current income and expenses, a minimal standard of living for himself and his dependents if forced to pay.
2.) That additional circumstances exist indicating that the current state is likely to persist for a significant portion of the repayment period of the student's loans.
3.) That the debtor has made good faith efforts to repay the loan.
The first part of that test is highly subjective and will change from court to court. In some cases the debtor will say "cigarettes are too expensive" and the court will tell him to quit smoking. On the other hand, some allowed expenses could be internet and phone. In some cases, cable is out of the question, but in other cases cable is fine because it isn't satellite. The second part of the test has to show that whatever the issues are, they are out of the debtor's control. Things such as a person having diabetes and resulting blindness was enough, as was asperger's syndrome with osteoperosis. Switching to a lower paying job by choice won't work because they will say you aren't maximizing your potential. The third part of the test has to show the debtor tried to repay the loan but couldn't because of the issues in the other parts. Trying alternative payment plans looks good, as does attempts at legitimate income maximizing and minimizing expenses.
Apparently 5 of 10 cases the debtor is denied discharge. 3-4 of 10 are close but don't quite have what it takes. And then there's maybe 1 legitimate case. It is very difficult to prove all three prongs of the Brunner Test, which is why they usually don't succeed. There have been attempts to change this setup, but it's unlikely it will change for awhile.

In the end, it's much easier and better for the student credit-wise to just work with their student loan servicer.

1 comment:

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