Discharging Private Student Loans Is Counterproductive

It will impair the future ability to borrow for an overwhelming majority of those in debt.

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John Hupalo is the founder and CEO of Invite Education, LLC.

These are daunting times for many recent college graduates who incurred record levels of federal and private student loan debt before facing a recession and the worst job markets since the Great Depression. They need help.

Some legislators believe meaningful assistance lies in amending the Bankruptcy Code to permit the discharge of private student loans in bankruptcy. It doesn't. Turning bankruptcy courts into turnstiles for the discharge of the least common form of student loan debt may temporarily assist some distressed borrowers, but the overwhelming majority will not be helped. Worse, the most vulnerable graduates could be exposed to ominous long-term consequences, impairing their future ability to borrow.

[Read Steve Cohen: Allow Private Education Loan Debts to Be Erased in Bankruptcy]

In response to the Consumer Financial Protection Bureau's report on private loans in July, Moody's Investors Service summed it up nicely: "Borrowers who have just left school are struggling to find jobs in the weak economy and are likely less concerned than more mature borrowers about the potential difficulty in obtaining credit after bankruptcy or by associated social stigma." Bankruptcy could be a trap for young borrowers who unwittingly trade the appeal of immediate debt relief for an underappreciated cost: a 10-year stain on their credit profile that makes other borrowing virtually impossible. An expedient bankruptcy at age 25 could substantially impair a 32-year-old who has moved to the next life stage but is denied a mortgage, car loan, or small business loan.

Another unintended consequence is a likely increase in the cost of debt for private student loan borrowers. Why? Each discharged loan is a significant loss to lenders, requiring them to reserve against such losses with costly capital. Initially, lenders will have little choice but to reserve more and offset this added risk by increasing interest rates. The resulting price hike to new borrowers will come at a time when they can ill afford it.

Three other arguments support maintaining current law. The first is equity for student loan borrowers. Some policymakers seek to strip non-dischargeability from private loans while maintaining it for federal loans. Decoupling identical bankruptcy protections will create confusion for borrowers.

[Check out U.S. News Weekly, an insider's guide to politics.]

Second, the Federal Reserve Bank of New York recently reported that credit underwritten private loans account for only 7 percent of annual loan volume. The remaining 93 percent are made by the government and are not credit tested. Why permit the discharge of a tiny percentage of the most creditworthy student loans while leaving the vast majority and least creditworthy loans subject to non-dischargeability? It's difficult to argue that this is in the interest of the majority of the most needy borrowers.

Finally, private loans are dischargeable today. Under current law, private student loans may be discharged when borrowers demonstrate economic hardship. The bar for judges to grant economic hardship and discharge is rightfully high to protect borrowers from the moral hazards and negative consequences of bankruptcy early in their lives as independent consumers. Importantly, the very small group of borrowers who truly need immediate relief can get it.

Policymakers deserve credit for seeking a meaningful solution to the vexing problem of excessive student debt now challenging a generation of college graduates and our economy. However, focusing first on discharging private student loans will not help the majority of graduates and could well be counterproductive.