Student loans are technically dischargeable in bankruptcy, but the process has always been convoluted.
A new bill is attempting to ease that process.
House Judiciary Committee Chairman Jerry Nadler (D-NY) and Sen. Elizabeth Warren (D-MA) on Wednesday introduced the ‘Consumer Bankruptcy Reform Act of 2020,’ which proposes to replace the current systems of chapter 7 and chapter 13 personal bankruptcies with one system, chapter 10, in addition to specifically addressing the eligibility of student loans for discharge in bankruptcy.
“The bankruptcy system is broken… it needs to be fixed,” Christine Kingston, a California-based attorney with Surf City Lawyers, said when asked about the bill’s proposed changes related to student loan borrowers. Kingston, who litigates student loan bankruptcy cases, noted that an American can “relieve themselves of their legal obligations” through bankruptcy after they “go to Vegas and gamble away their rent and mortgage” but “when they wanna better themselves, and get an education… then well, they better fly right and get it done accurately… not borrow too much.”
U.S. Senator Elizabeth Warren delivers the commencement address at the Lesley University commencement in Boston on May 19, 2018. (Photo by Jonathan Wiggs/The Boston Globe via Getty Images)
The legislation, co-sponsored by Sens. Dick Durbin (D-IL), Sheldon Whitehouse (D-RI), and David N. Cicilline (D-RI), proposes to amend title 11 of the United States bankruptcy code by adding a chapter 10, which among other things, would make student loans — private and federal — eligible for discharge through bankruptcy.
The bill aims to put student loan debt on “equal terms with most other types of debt” such as credit card debt, Warren said in a statement, as well as “make it easier and less expensive for financially-strapped families and individuals to obtain meaningful bankruptcy relief and give Americans a better chance to get back on their feet.”
Sen. Whitehouse added that he was “proud to support this sensible bill to allow Americans facing financial hardship to free themselves of student loan and medical debt."
(Graphic: David Foster)
‘These people are facing a lifetime sentence of debt’
On December 1, Warren pressed Federal Reserve Chair Jerome Powell on whether student loans were a drag on the U.S. economy.
Powell responded that he’s “singled it out for not being able to be forgiven in insolvency.”
President-elect Biden has also supported easing the standards that allows student debtors to cancel — or to use the legal term, discharge — student loans in bankruptcy.
Austin Smith, a D.C.-based attorney at Smith Law Group, who represents several student debtors in their bankruptcy process, told Yahoo Finance that this bill has serious implications for loan servicers. By Smith’s estimates, if this bill passes, $3 billion in private student loans that have already been through the bankruptcy process become eligible for cancellation.
In some of his cases, borrowers saw their student loans discharged through a court verdict but lenders didn’t agree with the verdict and continued to collect. These loans would be erased under the bill.
President-elect Joe Biden talks to graduating student Katherine Wu (R) ahead of the University's 366th Commencement Exercises at Harvard University in Cambridge, Massachusetts, U.S., May 24, 2017. (REUTERS/Brian Snyder)
An increasing number of student debtors are prevailing after submitting student loan bankruptcy petitions, seeing their private and federal debt either discharged or written down considerably.
Kingston noted that one of her clients who attended one of the now-defunct Art Institutes went through the bankruptcy process instead of the borrower defense process (which has its own issues) and saw their private student loan with Navient written down from $250,000 to $10,000 with an interest rate of 1%.
“These people are facing a lifetime sentence of debt,” Kingston told Yahoo Finance.
More broadly, “there is growing realization among bankruptcy court judges that the current standards are far too harsh,” Mark Kantrowitz, an expert on student loans, told Yahoo Finance. “Why should student loans be treated the same as child support or taxes and not like credit card debt? There's no real difference between student loans and credit card debt. They're both commercial loans that are unsecured.”
A person walks by the United States Bankruptcy Court for the Southern District of New York in Manhattan, New York City, U.S., August 24, 2020. (REUTERS/Andrew Kelly)
Student loan servicers like the current system
There will undoubtedly be considerable pushback from lenders who prefer to make the process inaccessible to borrowers. But experts see an opportunity to positively reform the system.
A recent paper by Jason Iuliano, an expert on student loans and bankruptcy, found that servicers often nudge borrowers to accept settlements — as opposed to letting the process play out — to avoid creating precedents that other student borrowers declaring bankruptcy could follow.
There is also this argument that because these loans are considered untouchable in bankruptcy, this allows lenders to offer better rates to borrowers because they are protected from being erased.
But “the argument that excepting student loans from discharge enables private lenders to make these loans to offer them cheaper loans just doesn't hold water,” Kantrowitz asserted.
Based on a 2007 paper by Kantrowitz, if Congress were to ease the process and allow more private student loan borrowers to go through bankruptcy, “it is unlikely to result in a significant decrease in private student loan availability to prospective borrowers with low credit scores.”
And of all the student loan reform proposals currently being considered — from forgiveness to overhauling the repayment system — easing the bankruptcy process would be “by far the cheapest,” Kantrowitz added.
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Aarthi is a reporter for Yahoo Finance. She can be reached at aarthi@yahoofinance.com. Follow her on Twitter @aarthiswami.
