Debunking the Student Loan Bankruptcy Myth

The belief that student loans are never dischargeable in bankruptcy is one that makes us here at the Student Loan Ranger cringe every time we see it -- and we see it a lot.

We cringe because it's not true. You actually can get your student loan discharged in bankruptcy in some limited cases. In fact, according to a study published in 2011 by Jason Iuliano , at least 40 percent of borrowers who do include their student loans in their bankruptcy filing end up with some or all of their student debt discharged.

The problem is the old tale that has consumers thinking there's no chance to have these loans discharged, so they don't try. Iuliano's report found that only about 0.1 percent of consumers with student loans attempt to include them in their bankruptcy proceedings.

[Read how one bankruptcy case may offer hope for student loan borrowers.]

To be clear, if you borrow money, you have a moral and legal obligation to pay that money back, even if that means making some financial sacrifices. It is strongly recommended that students do more cost-benefit analysis and long-range planning before taking on student debt of any amount.

But sometimes life throws students some pretty big curveballs that they just can't plan for or recover from, and it's in those cases that bankruptcy comes into play. If you're in that position, here are the most important things you need to know about student loans and bankruptcy.

The Student Loan Ranger is not an attorney and strongly advises you to consult one before taking any type of action related to this topic.

-- Check if you pass the Brunner test: Current bankruptcy law exempts education loans and obligations from eligibility for discharge unless doing so would cause the consumer undue hardship. The problem is that undue hardship is not defined within bankruptcy law, leaving the bankruptcy courts to decide what this means.

While all courts are different, many use what's called the Brunner test to determine if requiring a consumer to continue to be responsible for an education debt would cause him or her undue hardship. There are essentially three criteria a consumer has to meet under the Brunner test.

First, continuing to pay the loan must cause the borrower to be unable to sustain a minimum standard of living. Second, the borrower's financial situation must be unlikely to change in the future. Finally, the borrower must have made a good-faith effort to pay his or her loans.

[Watch out for signs of student loan company scams.]

If you think you meet these criteria, you will need to ask your bankruptcy attorney to file an adversary proceeding, which is essentially a lawsuit within the bankruptcy case itself. While you can technically file one of these yourself, due to the complex nature of these cases it is strongly recommended you retain a qualified bankruptcy attorney, preferably one with experience in student loans.

Investigate other possible discharge strategies: The bankruptcy code describes an education loan as one that, in part, was used to attend an eligible education institution, which is further defined as one that is eligible to participate in the federal student aid programs.

Some consumers have been successful in arguing that, because their private student loans were used to attend a school not eligible for these federal student aid programs, the loans don't fall under the definition of an education loan and should therefore be eligible for discharge.

Another part of a student loan's definition in the bankruptcy code requires that the loan be used for cost of attendance expenses as defined in the Higher Education Act. Cost of attendance expenses, for federal student loan purposes, are essentially tuition, fees and indirect costs related to your enrollment in postsecondary education. For example, a computer can be considered part of the cost of attendance, but only if it is required by the school.

With this in mind, some borrowers have argued that the portion of their student loan funds used for non-eligible educational expenses is dischargeable. This argument is risky, however, as most promissory notes signed by student loan borrowers contain a statement of educational purpose, which means by borrowing the loan, you agree to only use the funds for these very same cost of attendance related expenses.

[Here are five things to know before signing a promissory note.]

-- Weigh whether you should bother filing for bankruptcy: With all the new income-related repayment and forgiveness options that have been introduced over the last few years, most borrowers, especially those with federal loans, should be able to find a repayment strategy that is manageable, which makes meeting the criteria for the Brunner test a little more difficult.

But remember that bankruptcy is there for a reason, so if your debt is overwhelming and your life circumstances don't seem like they are going to allow you to fulfill these obligations in a reasonable way, then you may want to consider filing for this relief. Even if you don't meet the criteria for student loan discharge, it might be possible to discharge other debts, freeing up resources to allow you to pay the student loans.

In the end, you really only need to remember two things: work with a qualified attorney, and when it comes to student loans and bankruptcy, never say never.

Betsy Mayotte, director of regulatory compliance for American Student Assistance, regularly advises consumers on planning and paying for college. Mayotte, who received a B.S. in business communications from Bentley College, is a frequent contributor to ASA's SALT Blog; responds to public inquiries via the advice resource "Just Ask;" and is frequently quoted in traditional and social media on the topics of student loans and financial aid.