Hundreds of thousands of Americans who fall behind in their bills and seek refuge by filing for bankruptcy get a distressing surprise: If they are willing to ruin their credit for years, they can walk away from their houses, turn in their cars, and wipe out their credit card bills, but they typically can't erase a penny of their student debts.
Of course, the vast majority of Americans who use loans to pay for college get jobs and pay their debts. But the recent economic troubles and spike in unemployment have caused thousands of graduates to fall behind on their student loan payments. More than 20 percent of students who took out expensive private loans in the last several years to pay for tuition at some for-profit colleges have defaulted. The government reports that 6.7 percent of those who took federal student loans in 2007 have already defaulted, up from 4.6 percent in 2005. And many analysts predict more Americans will have trouble paying their student loan bills in the coming months.
Recent developments in Washington hold out new hopes for anyone struggling with student loans, however. Several Congressional Democrats, including Minnesota Sen. Al Franken and Illinois Sen. Dick Durbin, are pushing for a reform to allow those who file for bankruptcy to get out from under at least some of their private educational loans.
"In this economy, we want to be encouraging people to invest in their education and their future," Franken said in a press release. "That's why it is more important than ever for people to be able to get a fresh start."
If the plan wins Congressional approval, it would mark the third big improvement in student loans in the last year, student groups say.
Last summer, the federal government started allowing those with federal student loans to cap their payments below 15 percent of their income, and it promised to forgive some of the debts of public servants, and those with low incomes. Earlier this year, Congress beefed up the new "Income-Based Repayment" plan so that those who take out federal student loans after 2014 can cap their payments below 10 percent of their income.
[Get the details on income-based student loan repayment.]
In March, the Supreme Court set a small but hopeful precedent for borrowers. It backed a borrower who had persuaded a bankruptcy judge to reduce his federal student loan debt, rebuffing attempts by a collector to reinstate the entire debt.
Now that federal borrowers have a chance at relief, attention is turning to the estimated 17 million Americans currently paying down private student loans. Valisha Cooks, a University of Phoenix graduate and single mom who lives in Long Beach, Calif., told Congressmen at an April 22 hearing on the Congressional proposal that she's glad the new income-based repayment plan allows her to pay down her federal loans. But she said debtors like her need "a light at the end of the tunnel" for private loans. Although Cooks filed for bankruptcy, Wachovia has refused her efforts to negotiate an affordable payoff plan, and keeps adding interest and fees to her original $36,000 private loan. Today, she figures she owes Wachovia $53,000. "I send them whatever I can afford each month--usually about $120," but she says collection agencies "still call and threaten to send my account for wage garnishment. I live in constant fear that the hammer will one day drop and ruin my life and any hope for my son's future. It's a scary, hopeless feeling."
A spokesperson for Wachovia, which was purchased by Wells Fargo at the end of 2008, says it offered Cooks a chance to skip six months of payments, though it would keep adding interest during that time. As for the Congressional proposals, Wachovia said it went along with its trade organization, the Consumer Bankers Association, which warned Congress that offering relief to current debtors could hurt future students. "If this legislation passes, lenders will face increased losses from loan defaults. This will result in higher fees, higher interest rates and even tighter credit screening—the opposite of what is needed to expand access to affordable higher education," the CBA stated.
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."
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.
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