By David Bernstein
The current generation of students is leaving school with more debt than any previous generation. While postsecondary education remains a good investment for the average student loan borrower, some borrowers will never be able to repay their student loans in full. Moreover, current bankruptcy law and procedures make it very difficult for borrowers with student debt to ever obtain a fresh financial start.
At the federal level, there is some interest in policies that might alleviate student loan debt burdens. The desire to provide student debt relief to borrowers is tempered by concern about the cost to taxpayers when this government guaranteed debt isn’t fully repaid. In my view, it is possible to provide a modest level of student debt relief to borrowers without imposing substantial costs on taxpayers. This could be accomplished by modifying the Income Based Replacement (IBR) Loan Program and through changes to the bankruptcy code.
The IBR program, enacted in 2009, provides four benefits to student loan borrowers.
In addition, some student loan borrowers who maintain payments through the IBR program will be able to utilize public loan forgiveness programs
The primary purpose of the IBR program is to prevent borrowers from defaulting on their student loan when their household income is low compared to qualified student loan debt. Only student loan borrowers with chronically low levels of household income can receive some debt forgiveness. Borrowers who receive lower payments through the IBR program will often pay more on their loan than if they remain in the standard 10-year payment plan.
The IBR program is complex and does not offer assistance to many overextended student loan borrowers. First, the IBR program does not cover PLUS loans made to parents, private loans, or consolidated loans that include a parent PLUS loan or a private student loan. The decision to consolidate 10-year loans into a 20-year loan could also make borrowers ineligible for the IBR program. To fully benefit from the IBR program, borrowers need to be aware of IBR rules long before they are aware that they will need IBR, when they are borrowing or consolidating federal student loans.
Second, the IBR program often provides little or no relief to a household that has high levels of both consumer debt and student loans. The IBR program is especially complex for married households. A single person who qualifies for the reduced IBR loan payment could lose this benefit if he or she marries someone with high levels of consumer debt, even if household debt-to-income ratios increased after marriage. Married individuals could choose to file separate tax returns to take advantage of the IBR program, but that decision usually results in a larger tax obligation.
It is impossible to modify the IBR program to account for consumer debt without creating an incentive for additional borrowing. Borrowers with high levels of student debt and consumer loans might seek relief in bankruptcy courts. However, current bankruptcy laws and procedures offer little relief for borrowers with student loan debt.
There are two ways debtors can seek student loan debt relief in bankruptcy. First, the debtor could petition the court for a complete or partial discharge of student debt. Second, in a Chapter 13 bankruptcy the debtor could petition the court for a payment plan that favors the repayment of student loans over the repayment of other unsecured loans. Neither remedy is easily obtained.
To discharge student debt in bankruptcy, the borrower must prove that he or she has an "undue hardship." Most courts require that the borrower show a "certainty of hopelessness" for his or her financial situation over the repayment term of the loan. A certainty for hopelessness is extremely difficult to demonstrate because there is some probability circumstances will improve, even for individuals in extremely dire circumstances. An August 31, 2012, New York Times article describing the petition of a legally blind, unemployed man illustrated the hurdles a student loan borrower must clear in order to have student debt discharged in bankruptcy.
Any proposal that makes it easy to discharge government guaranteed student loans in bankruptcy entails some additional cost to the taxpayer. However, it is easy to envision a less stringent student loan discharge rule that does not significantly increase taxpayer costs. Such a rule would rely on objective criteria rather than the subjective "undue hardship" concept. For example, student loan discharge could be limited to individuals with incomes near poverty level, contingent on participation in the IBR program, favor individuals with medical problems, and allow for partial, rather than full, loan cancellation.
Two other aspects of the bankruptcy code have a substantial impact on financial outcomes for student loan borrowers in bankruptcy and for the government agencies that hold or guarantee student debt. First, financial outcomes are affected by the rules governing whether a debtor can obtain a Chapter 7 bankruptcy or a Chapter 13 bankruptcy. Second, financial outcomes are affected by the rules governing repayment of student debt and other unsecured consumer loans under a Chapter 13 repayment plan.
Under a Chapter 7 bankruptcy, the bankruptcy court will immediately discharge most unsecured consumer loans. In a Chapter 13 bankruptcy plan, debtors must file repayment plans with the bankruptcy court. The repayment plan determines how much debtors can repay creditors and the amount received by each creditor. Prior to the 2005 bankruptcy law, debtors could choose to either file under Chapter 7 or Chapter 13. The 2005 bankruptcy law created a means test that required many individuals with incomes over the household median to file Chapter 13 rather than Chapter 7.
When student loans are dismissed under Chapter 7 bankruptcy, the borrower gets an immediate fresh start and can use all the newly available funds for the repayment of student debt. A borrower who obtained a deferment prior to bankruptcy can immediately renew payments on his or her student loan. By contrast, when borrowers are placed into a Chapter 13 repayment plan, the amount allocated to the payment of student loans might not even cover interest and, in many circumstances, the debtor will leave bankruptcy with a substantial student debt intact.
Student loan borrowers in Chapter 13 can petition the bankruptcy court to allocate a greater amount of their payment plan to the repayment of student loans and a lower amount to the repayment of other unsecured credit card debt. However, most courts tend to favor a payment plan that does not discriminate against any class of unsecured creditors. As a result, many student loan debtors emerge from the bankruptcy process five years older with a substantial amount of unpaid student loans. Many individuals experience decreases in income and have fewer job prospects after age 50. A delay in repayment of student loans caused by a forced entry into a Chapter 7 bankruptcy plan will increase financial exposure to taxpayers, increase student loan default rates, and decrease collection rates.
A revision of Chapter 13 bankruptcy rules that gives priority to student debt payments over other unsecured debt payments in bankruptcy would provide student loan debtors with a fresh financial start and would ultimately reduce taxpayer losses. Unsecured creditors would still enjoy greater collection rights than existed prior to the 2005 bankruptcy law.
Under current law, very little debt relief is offered to overextended student loan borrowers experiencing substantial economic hardship. Several policy changes might provide modest debt relief to these borrowers, maintain strong incentives against default, and protect taxpayer interests. These policies include:
The goal of debt forgiveness policies inside and outside of bankruptcy is to balance two competing objectives: providing overextended borrowers a fresh start, and fair treatment towards creditors. The pendulum may have swung too close to the creditor, especially with regard to the treatment of student debt.
The author is a retired economist who worked in the Office of Economic Policy of the U.S. Treasury from 1988 to 2012. He publishes a blog www.economicmemos.com
Publication Date: 10/23/2012