arguments for student loan bankruptcy

The Case for Student Loan Bankruptcy

Michael Lux Student Loan 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.

Bankruptcy on Other Debt

Student loans are treated uniquely in the bankruptcy world.  If a consumer gets into trouble with credit card debt, car payments, or a mortgage bankruptcy offers a path to a clean slate.  Student loan bankruptcy requires the borrower to bring an action against their lender and meet a very high standard for discharge.  This complicated system means many bankruptcy lawyers will not deal with student debt.  It also means that the people in dire financial circumstances cannot afford representation for these cases.

Comparing student debt to small business debt provides some interesting insight.  Suppose we have two high school grads.  One decides to start a business and the other heads off to college.  From an economic standpoint, both are activities that our government should encourage.   We want an educated workforce and we want people to create new businesses.  If things go south for our two recent grads, the business owner can declare bankruptcy and get a fresh start.  The student is likely stuck with the debt for many years to come.

There simply is no reason for student loan lenders to get special protections that banks and lenders do not receive for other types of loans.

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.

Many 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.

Another way of looking at the situation: who is in a better position to evaluate the quality of schools?  A 17-year-old high school senior’s analysis can’t compare to large corporation with access to borrower repayment data and teams of analysts.

At present, lenders have no incentive to guide borrowers to the schools and programs with strong job placement.  Because there is little to no threat of bankruptcy, the lenders know they will get paid no matter where the student goes.  If bankruptcy becomes a real threat, lenders will have to make sure the money they send out has a strong chance of getting paid back.

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 with 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.

Subscribe
Notify of
guest
11 Comments
Oldest
Newest
Inline Feedbacks
View all comments
Money Beagle

This would be a tough sell simply because of the lobbying that would be done to prevent the change by the banks that profit significantly from the current laws. The best time to have done this would have been during the 2008-09 financial crisis as the banks were pretty much on the outs with the government. Now, I think they’ve wiggled their way back in to having a seat at the table, so I don’t see it as something that will gain traction anytime soon.

The Student Loan Sherpa
Reply to  Money Beagle

I’m afraid you are right about this one. Advocacy for student borrowers is really lacking and the banks have a huge financial incentive to keep things unchanged.

Anthony_Eller
Anthony_Eller

I have been following this mess for the last 5 years I write a blog on trying to find solutions to the now $1.2 Trillion student loan debt. By the way the student loan debt was $850 Billion when I started following this mess! I think that the student loan system has become outdated and corrupted on all sides. This has all started with the children that are ill prepare to be signing student loans that will effect the rest of their lives if their not informed correctly. ..the schools that now have more administrators than professors in some cases turning colleges into resorts….the lenders that now are also debt collector. Where if changes are not made soon more profits will be made off the student loan defaults than the actual student loans.and it’s
Congress that has been bought and paid for by the lenders lobbyist..the lenders. and special interest .That are trying to convince the voters that they will stuck with paying for a generation of lazy kids and that low interest rates will solve the whole problem. And we can’t leave the media out that are saying what they have told to report…..which is total BS
It’s time to rethink the whole student loan system!

Your thoughts

Anthony_Eller
Anthony_Eller
Reply to  Anthony_Eller

I’ll leave you with a layman way of looking at the increase in the student loan debt. In seconds
$ Million is 11.5 days…..a $Billion is 31.5 years…..and $ Trillion 31,56887 years
This is the future of our Great Country our children

” A baby comes into this world with hope. ..the only gold we will leave this earth with is our. …..word”
Anthony Eller

krantcents

One of the unintended consequences would be higher interest rates to make up for their losses. Even the U.S. government cannot afford losses on loans they guarantee. Someone would have to make up the losses and I bet it would be the borrowers.

The Student Loan Sherpa
Reply to  krantcents

Higher interest rates are definitely a possibility, and it would likely prevent some lending. However, the alternative would just be more irresponsible lending and putting more students in terrible situations.

Messy Money
Messy Money

I have mixed feelings about this. I paid for school myself (with a small amount of help from my parents-but I still had to work for the $ my parents provided) I did not take any loans and it was really tough. The people that had student loans seemed to be living the highlife while I was working and going to school. Maybe I am just bitter. I think the whole concept of higher education needs to be examined – there has to be a better way. A degree should not be the minimum requirement for most jobs.

The Student Loan Sherpa
Reply to  Messy Money

You make a very interesting point about the degree requirement for jobs. I think there are a lot of people trying to figure out whether or not they really needed that piece of paper they spent so much money on.

Stu @ Poor Student

I agree to the alternative that you suggested. Top universities offer high quality of education, and the students who get accepted into one of these universities should be able to attend it without financial barriers. On the other hand, students who choose to go to a shady school should think twice (and hard) before they decide to take out loans, since it’s not too uncommon we hear for-profit schools don’t really care about their students, both the students’ education and the students’ finances.

The Student Loan Sherpa

I’m inclined to think it is the best route too. All college educations are not created equal, so anything that helps people separate the good ideas from the bad ideas is a step forward.

Anthony Eller

Well guys here your chance to help reinstate student loan bankruptcy….Students are the only individuals that their student loan consumer protection rights have been taken away please sign the petition

http://www.petition2congress.com/17294/requesting-cosponsors-to-discharge-student-debt-through-bankruptc/

It time all sides are held accountable not just the student Our country was build on second…third chances bankruptcy is even written into our Constitution!
I now have several years writing on the student loan debt it was $850 Billion when I started! it’s approaching $1.3 Trillion!