There is an old adage dating back to the 1700s that the two most certain things in life are death and taxes. But for families with certain types of student loans, having to make payments on their loans is another certainty. Students used to be able to discharge educational loans in bankruptcy, but that ability was first restricted in 1976 before being fully eliminated for federal loans by 1998 and private student loans in 2005. The growth of income-driven repayment programs for federal loans reduces the need to discharge these loans in bankruptcy, as payments would instead be zero if a student signs up for this plan and earns below the poverty line.1 But private loans, which are about $10 billion per year, generally do not offer income-based repayment options.
Neal Hutchens of the University of Mississippi and Richard Fossey of the University of Louisiana have an interesting new piece up at The Conversation that argues that private student loan debt should once again be dischargeable in bankruptcy. They contend that more students should be able to meet the “undue hardship” test for paying off private loans, which includes both having low income and making a good-faith effort to repay loans. Senate Democrats, such as Elizabeth Warren of Massachusetts, have pushed for making private loans dischargeable in bankruptcy, and the Obama Administration has expressed interest in the idea.
But making private student loans dischargeable in bankruptcy would likely come with two main drawbacks for borrowers. The first one is that private lenders would significantly increase their standard for creditworthiness, thus rejecting students who need money for college but do not (and their co-signer does not) have outstanding credit. The second one is that interest rates would rise to take into account the increased risk that borrowers do not repay their loans. Currently, the terms on private loans are generally comparable to PLUS loans. If a student gets denied a PLUS loan (or a college doesn’t package a PLUS loan into a student’s financial aid package), the terms on private loans may become so bad that students and parents don’t wish to consider this option—even with the protection that discharging a loan in bankruptcy would offer.
The traditional market for private student loans is at a crossroads right now, with the terms on many types of federal student loans getting much better in recent years while the growing student loan refinancing market and the potential for income share agreements have the potential to threaten traditional lenders’ business models. But in the meantime, advocates for allowing students to discharge private loans in bankruptcy need to carefully consider the tradeoff between protecting some of the most vulnerable students who fall upon hard times and potentially restricting access to needed credit for other students to attend college. Which of these two factors is more important? It’s hard to tell at this time, but both need to be carefully considered by policymakers.
1 Parent PLUS loans qualify for a far less generous income-driven repayment plan than all other federal loans, but payments would still be zero if the parent earned below the federal poverty line