Should student loans be dischargeable in bankruptcy?
About seven million borrowers are in default on their federal student loans, and a record amount of unpaid student debt is past due. There is a well-known concern that defaulting on student loans will hamper economic growth and hurt students for years to come. Policymakers have responded to this concern with a wave of proposals for laws and regulations relating to student loan repayment, and have also produced broader proposals to reform the structure of higher education funding.
An important element, but less frequently considered in this policy discussion, is the way in which student loans are treated in bankruptcy proceedings. This has become of greater concern now that so many borrowers are struggling to repay their student loan debt and, therefore, will require attention even if student loan programs are overhauled. The crux of the matter is that student loans are not dischargeable except in limited circumstances, which means borrowers are forced to repay their student debt even after declaring bankruptcy. Recent proposals attempt to overturn non-discharge laws, but would making student loans dischargeable in bankruptcy lead to more defaults?
The discharge debate
The political debate is full of conflicting views: some argue that the incentives to abuse the bankruptcy system are high and threaten the survival of student loan programs, while others argue that the impact of opportunism is insignificant. and therefore does not deserve the burden that non-liberation imposes on people in difficulty. debtors.
US bankruptcy laws provide the “honest but unhappy” debtor with the opportunity to recover financially after experiencing hardship. Bankruptcy is costly for lenders because it reduces the expected return on funds disbursed. Bankruptcy is also costly for debtors because it damages credit scores and makes borrowing more difficult in the future. Nonetheless, bankruptcy can have many benefits when used wisely. Most see it as essential to credit market operations as it arbitrates the claims of creditors against the borrower. Bankruptcy also promotes the post-bankruptcy productivity of debtors by giving them the opportunity to start from scratch, without being burdened with pre-existing debts.
Some policymakers have long feared that many student loan borrowers who file for bankruptcy are neither honest nor unhappy. As a result, federal student loans have been considered non-dischargeable since the 1970s, and bankruptcy reform in 2005 extended non-discharging to private student loans.
Therefore, most student loan borrowers cannot take full advantage of bankruptcy relief because they retain the responsibility of paying off student debt. There are hard exceptions to non-discharge laws, but the appeal process has been criticized for being arbitrary and can be expensive and arduous.
Why are student loans treated differently in bankruptcy? In the past, debtors could settle their student loan debt in bankruptcy by assigning their assets. However, recent college graduates often have few assets to give up, even though they have high expected future incomes. As a result, the worry is that the opportunists could play with the system by accumulating large debts that they never intend to pay off as they may file for bankruptcy on the eve of starting lucrative careers.
Without restrictions to guard against this moral hazard, lawmakers argued that student loans would be ripe for fraud, that is, they would be too easily discharged in the event of bankruptcy. This could ultimately reduce the availability of student credit and possibly even destroy student loan programs. The unique nature of student loans complicates actions that guard against this behavior. Borrowers do not place collateral against their student loan debt, and the interest rates charged to borrowers often do not fully reflect their risk of default or are not risk-rated at all.
Proof of bankruptcy filings
To shed light on this debate, a colleague and I analyzed millions of anonymized credit bureau records to examine whether bankruptcy filing behavior has changed as a result of the 2005 law that made student loan debt private. not releasable. The private student loan market is estimated to represent approximately $ 150 billion of the $ 1.2 trillion in outstanding student debt. The private student loan market, in particular, has been the target of recent legislative proposals that attempt to roll back non-liberation. This is because unlike federal programs which are subsidized by taxpayers and where the public would be responsible for covering the costs associated with default, private lenders can build risk into the terms of their student loans. Aggravating criticisms of the non-availability of private student loans are allegations that these provisions were slipped into the 2005 legislation without proper verification.
If private student loan debtors behaved opportunistically before the policy, we would have expected a large relative decline in bankruptcy filings after the 2005 provision hampered their so-called opportunistic behavior, compared to debtors whose incentives did not exist. ‘were not directly affected by the non-release clause. However, we do not find evidence of such a reduction. In other words, our analysis does not reveal any responses to the 2005 bankruptcy reform that would indicate widespread opportunistic behavior on the part of private student loan borrowers prior to the policy change. Our results do not rule out the possibility that some filers were playing with the bankruptcy system, but we do not find the behavior to be pervasive.
Until student debt can be discharged in bankruptcy, it will carry magnified financial risk, as struggling students might not be able to get the “fresh start” that the bankruptcy system aims to provide. This risk is of particular concern, as new analysis indicates that those most likely to default on their student loans are relatively vulnerable – more likely to come from low-income families and live in poorer, less susceptible neighborhoods. to complete their post-secondary programs and achieve well-being. paid work.
Our analysis suggests that policymakers may not have to worry so much about the potential for abuse of the bankruptcy system; however, it also indicates that the 2005 non-waiver policy change increased the availability of student loan credit. Therefore, if the non-exemption laws were rescinded, it is likely that private student loans would be less accessible and more expensive for many borrowers. There are many concerns that students who currently rely heavily on private loans are not making informed decisions, as these loans generally have less attractive terms than federal loans. Nonetheless, private student loans have been used to meet financial needs unmet by public programs and to compensate for the lack of access to federal loan programs in some schools, including many community colleges.
The expected reduction in the availability of credit may make policy makers reluctant to completely repeal non-availability laws for student loans. If so, establishing clear and accessible guidance on the standards debtors must meet in order to obtain an undue hardship exception could be an improvement. The need to appeal will always be a substantial barrier for many struggling student debtors, so policymakers might also consider supports that facilitate hardship appeals among those who deserve it.