New Hope for Debtors Struggling With Student Loans

Congress mulls making it easier to erase student loans in bankruptcy


Albert Lord, chief executive officer of Sallie Mae, a leading educational lender, told analysts that a law change that would make it easy for students to abuse bankruptcy and cancel their education debts would be "very troublesome for young people ultimately and for the availability of credit." Sallie Mae supports reforms that would allow debtors a break if they file for bankruptcy after, say, five years of trying to make payments, he said. And he feels that Congress ought to allow troubled debtors to clear all student loans—including federal ones. But in a grudging nod to supporters of the reform, Lord said the Congressional proposals would have a "pretty small" impact on the company's profitability. "We don't see anything catastrophic there," he said. 

Academic researchers also predict mixed results. Making it easier for to reduce or eliminate private student loans could encourage more people to file for bankruptcy, found Colgate economist Felicia Ionescu. But the negatives would likely be more than offset by a bigger increase in the number of people who go to college, learn skills, and increase their earnings, she concluded. 

The history of student loans also casts some surprising lights on the bankruptcy rule's possible impact. Until the last decade or so, just about the only college tuition loans generally available were those backed by the federal government, such as Stafford and Perkins loans. Since federally backed student loans were made to all citizens, without regard to credit, at comparatively low rates, Congress decreed in 1978 that they should be treated something like tax debts, which are very difficult to avoid paying. The government only allowed those filing for bankruptcy to wipe out their student debts if they proved the payments would cause an "undue hardship." 

But the government tried to rein student borrowing by only allowing students to take out a few thousand dollars a year, even though colleges' tuitions were skyrocketing. In the 1990s, a growing number of banks, and other for-profit lenders started making private student loans—which were business transactions without any government involvement. When people with private loans found themselves in financial trouble and filed for bankruptcy, judges lumped those with other private debts such as credit cards, and often wiped the slate clean. 

That changed in 2005, when an anonymous Congressman—no one has publicly claimed credit yet—slipped an amendment into a bankruptcy reform bill that made all private student loans, even those already made, as inescapable as federal student loans. 

Now, graduates who get into financial difficulty can apply for income-based repayment on their federal loans to lower their bills without defaulting. But the estimated 17 million Americans with private educational loans still can only try to negotiate with lenders, or persuade a bankruptcy judge that they have an "undue hardship." 

[Read 6 Advantages of Federal Student Loans.] 

Unfortunately, neither of those options holds out much hope for those in trouble. Lenders have been at least as loathe to help troubled student borrowers as they have to help those with unaffordable mortgages, lawyers and borrowers say. 

Deanne Loonin, director of the Student Loan Borrower Assistance Project for the National Consumer Law Center, says those who try for relief in bankruptcy court face dismal odds. Bankruptcy courts require such debtors to go to a full hearing, which typically costs thousands of dollars in attorney bills on top of the standard bankruptcy fees. Since people generally file for bankruptcy because they don't have any money, most can't afford the lawyers' fees to challenge their student debts, Loonin says. The few who do manage to make it to the hearing often lose because judges often require them to "somehow prove that their future is as hopeless as their present," which is "nearly impossible," says Loonin. 

Supporters of the bankruptcy reform proposal say giving unemployed and struggling Americans a chance to start fresh will have little downside. Since interest rates didn't drop when the law was changed in lenders' favor in 2005, there's no justification for them to jump if the law is changed back, the supporters argue. The Institute for College Access and Success noted, for example, that Sallie Mae's profit margin on private student loans increased every year from 2003 through 2007—before and after the law change. TICAS president Lauren Asher noted that lenders can wipe their own books clean of bad debts by simply writing them off. But then the banks sell those bad debts to collection agencies, who don't give students the same kind of chance to start fresh. "People who borrowed for college and played by the rules deserve basic consumer protections and fair treatment when they hit hard times," she says.