The Case for Student Loan Bankruptcy

Michael Lux Blog, Student Loans 11 Comments

One of the sad realities of the current student loan system is that lenders have very little incentive for responsible lending.  Many student loan advocates suggest that bringing back bankruptcy to student loans is the solution.  Banks, lenders, and their allies like to argue that if bankruptcy or other consumer protections were added to student loans, the lending would stop and many students would not be able to attend college.  However, applying many of the lessons that we learned from the mortgage crisis, we are given examples of how lenders can act responsibly without the ability to get loans disappearing.

The Case for Bankruptcy

Banks and lenders have spent a lot of time and money to remove bankruptcy protections from student loan laws.  They have been very successful in this effort.  As the law currently stands, a federal judge must determine that a borrower meets a rigid criteria in order to have student debt discharged in a bankruptcy.  This process makes it almost impossible for most borrowers, especially those with major financial problems, to get bankruptcy protection on their student loans.

While reinstating broad bankruptcy protection to student loans might cause interest rates to increase and might even result in some students not getting loans, it would also force lenders to act more responsibly.  Students would be less likely to get loans that they later regret.  Here at this site, we have also suggested an opt-in bankruptcy system that makes bankruptcy an option for borrowers, but also gives lenders an opportunity to work with borrowers to find an option that fits everyone’s needs.

The bottom line is that too many students or cosigners have their lives dramatically altered, in ways they never imagined, because of student loans.  Affording bankruptcy protection of some sort would give them the path they need to get a fresh start.

Letting the free market work in the 21st Century

Restoring bankruptcy to student loans also would allow for responsible lending in ways that were not possible in the 70’s when bankruptcy limitations on student loans were first enacted.  Today large corporations such as banks, lenders, and retailers have access to, and analyze, far more data than ever possible before.  Target famously identified one teen’s pregnancy before her father, based upon data analysis alone.  This detailed analysis could be used for both schools and majors.  In a student loan world with bankruptcy, a bank could charge much lower interest for an individual seeking an engineering degree from MIT, or charge much higher interest if that individual decided to change schools to enroll in a shady for-profit university’s basket weaving program.

This market driven solution would allow consumers, aka potential students, to be better informed before making college decisions.  Lenders would only care about a student’s ability to pay back debt, and these large companies would be in a much better position to evaluate the quality of a program than a recent high school graduate.

An alternative to complete bankruptcy

Right now, risky lending is a huge strain on borrowers and the economy.  Lenders and colleges continue to profit.  If restoring complete bankruptcy protection isn’t an option, then perhaps partial protection would be a better alternative.

One alternative would be for students who went to schools would high default rates or other high risk factors to be eligible for bankruptcy.  If the Department of Education defined certain schools as “risky”, only students who borrowed money to go to these schools would be eligible for bankruptcy of their loans.  We have recently seen the federal government do a great job identifying schools with risky student loan programs.  If lenders knew they were more at risk for certain loans, they could encourage students to seek out less risky programs.

This would force lenders to act more responsibly and force schools to do a better job lowering tuition and helping their graduates find jobs.  This option wouldn’t help all students, but it would definitely help filter out some of the worst schools that are in business largely to take advantage of students.

Why the change?

A high school graduate is among the least qualified in our society to objectively evaluate the quality of a school.  With the current student loan laws, these young people who make ill advised decisions are stuck with life altering debt.  Changing the bankruptcy laws could change the lives of many young people in a meaningful way.