The rules for student loans in bankruptcy have changed a lot over the past 50 years.
Sadly, nearly every single change made it more difficult for borrowers to discharge their loans in a bankruptcy proceeding.
The Old Rules for Student Loans in Bankruptcy
Until the late 1970s, student loans were treated like most other debt in a bankruptcy proceeding. There were no special rules for student debt, and a discharge was a straightforward process.
This system protected all borrowers, not just the ones who couldn’t afford their debt. Lenders had a reason to avoid lending money to borrowers so they could attend lousy or overpriced schools. Additionally, lenders had a big incentive to work with borrowers to ensure they could eventually pay off their debt.
Eroding Borrower Protections in the 1970s
Things first changed for borrowers in 1976 when Congress passed a law prohibiting the discharge of federal student loans within five years of graduation unless it would cause the borrower an “undue hardship.”
Sherpa Tip: Pay special attention to the term undue hardship. Alterations to the definition and application of the undue hardship standard show how much things have changed for borrowers in a relatively short period of time.
At the time, this change didn’t seem particularly controversial. It’s fairly reasonable to expect that borrowers fresh out of school won’t need bankruptcy protection for their student loans. Additionally, the undue hardship exception meant that borrowers fresh out of school but facing a challenging situation could still discharge their debt.
With the benefit of hindsight, this change has become far more controversial. It appears to be an example of Congress fixing a problem that didn’t exist. At the time of the passage of this first bankruptcy limitation, less than 1% of federal borrowers sought bankruptcy protection.
Things Get Worse for Student Loan Borrowers in the 1980s
The requirement that borrowers had to be in repayment for at least five years continued into the 80s. One noteworthy change was that the 5-year rule was expanded to apply to federal and private loans.
In 1987 things changed significantly.
The landmark case of Brunner v. New York defined the term undue hardship. The new definition made it extremely difficult for a borrower to get student debt discharged. Today, most borrowers live in jurisdictions where the Brunner Test is still applied.
Taking a Step Back: The Brunner Test is a difficult standard to meet, but it is worth noting that at the time of the Brunner decision, borrowers only faced this high hurdle if they had been in repayment for less than five years.
When the Brunner court defined undue hardship, they knew that a borrower who had been in repayment for greater than five years wouldn’t be subjected to the challenging standard.
The Final Decimation of Borrower Protections
In 1990, Congress changed the 5-year repayment requirement to 7 years. This meant even more borrowers would have to meet the challenging undue hardship definition.
In 1998, the 7-year requirement was erased, and all federal borrowers had to prove an undue hardship to get their loans discharged.
In 2005, private loan lenders successfully lobbied to have private loans treated the same as federal loans in bankruptcy.
Thus, for more than a decade, getting student loans discharged in bankruptcy was nearly impossible. Private lenders and the federal government consistently won in court, and many bankruptcy attorneys refused to even attempt to get student loans discharged.
Sherpa Thought: Erasing borrower protections in bankruptcy hurts all students. Lenders have little incentive to investigate school quality, and schools can raise prices with the knowledge that loans are easily attainable for most students.
Hope on the Horizon
For the first time in generations, things may finally be getting better for federal student loan borrowers in bankruptcy.
In November 2022, the Department of Justice revised how it would handle federal student loans in a bankruptcy proceeding. These new standards will make it easier for borrowers to show an undue hardship and empower more bankruptcy attorneys to take student loan cases.
We don’t know the full impact of the new rules, but there is plenty of reason for borrowers and advocates to be optimistic.
The History of Student Loans and Bankruptcy
For years I held off writing this article.
The history of student loans in bankruptcy is a story of gradually eroding borrower protections until it reached the point where a bankruptcy discharge became nearly impossible.
The news was all bad.
Fortunately, there is now a glimmer of hope. There is a growing recognition that the current bankruptcy rules don’t work. The new DOJ standards alone may be enough to help many borrowers.
