Student Loans: The Next Debt Crisis?

In the shadows of the mortgage crisis looms another debt monster threatening the American economy: student-loan debt.

According to the Federal Reserve Bank in New York, by the fourth quarter of 2011 outstanding student-loan debt reached an estimated $867 billion; a more recent estimate by the Consumer Financial Protection Bureau puts this number over $1 trillion. By comparison, an article by Southern California Public Radio indicates that the total amount of U.S. student debt now exceeds the combined total of credit-card debt and automobile loans.

When good-paying jobs are difficult to find, student-loan burden can impact the financial well-being of recent graduates. According to Forbes, 25 percent of the class of 2005 who began student-loan repayments the same year as graduation have been delinquent on at least one payment, and 15 percent of the class have defaulted on their student loans.

Student-loan debt doesn't just impact the individual borrower, though; it also negatively impacts the wider U.S. economy.

"There are repercussions for the broader economy. If consumers are unable to spend because of student loan debt, that's a drag on the economy," said John Rao, vice president of the National Association of Consumer Bankruptcy Attorneys, according to Forbes.

Rao notes that even in a good economy people with student-loan debts are often unable to purchase expensive items like cars and homes, a problem only magnified in a down economy.

People struggling to make ends meet because of debt often are able to find relief through bankruptcy, but for those struggling with student-loan debt, bankruptcy may not provide the relief they anticipate.

Undue Hardship

Receiving a fresh start by discharging student-loan debt through bankruptcy is extremely difficult. Yet, it is not impossible.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) made student debts priority debts. This means that even after the bankruptcy process is complete, all student-loan debt will remain in place and the debtor will still be required to repay it. Historically, private student loans were dischargeable during bankruptcy, but the BAPCPA changed this.

In order to have student-loan debt discharged in bankruptcy, the debtor must show the court that the student loans are an "undue hardship" on the payer, his or her family, or his or her dependents. Generally, proving undue hardship requires a showing that:

  • The debtor is unable to maintain a minimum standard of living and repay the student loans;
  • The debtor's current situation is unlikely to change or improve for an extended period of time; and
  • The debtor has made "good-faith efforts" to repay the student loans.

Bankruptcy May Still Be an Option

While most people's student-loan debts may not be eliminated through bankruptcy, filing for bankruptcy may still provide overall relief if they are shouldering other potentially dischargeable debts such as credit-card debt, mortgage debt or medical bills. Typically, debtors have two options for bankruptcy: Chapter 7 and Chapter 13.

Chapter 7 bankruptcy, or liquidation, allows for the immediate discharge of most debts at the end of the bankruptcy process. In Chapter 7 bankruptcy, debtors are able to keep certain "exempt" property, but may lose their nonexempt property, including houses and cars worth over a certain amount, in order to pay back creditors. Not everyone will be eligible to file Chapter 7 bankruptcy however, as debtors' eligibility is determined through a "means test."

Debtors who do not qualify for Chapter 7 bankruptcy, and those who own property such as a house that they would like to try to keep, may be eligible to file for Chapter 13 bankruptcy. Known as wage earners' bankruptcy, Chapter 13 bankruptcy involves debtors entering into repayment plans for three to five years; any debts that remain at the end of the repayment plan are discharged. Chapter 13 bankruptcy allows debtors to catch up on mortgages in arrears.

Even though student loans will most likely not be eligible for discharge through bankruptcy, filing for either Chapter 7 or Chapter 13 bankruptcy may allow a debtor to free up cash to make student-loan payments by eliminating other debts.

Discussing your financial situation with an experienced bankruptcy attorney will help you explore all of your options so that you can make decisions about your financial future that are best for you and your family. Student loans can be burdensome, but there are options for relief.