FinAid | Answering Your Questions | Bankruptcy and Financial Aid

Bankruptcy and Financial Aid

This page answers common questions about the relationship between bankruptcy and financial aid, such as student loans. The first answer concerns the impact of bankruptcy on eligibility for student loans. The second answer discusses whether student loans can be discharged through bankruptcy.

Thanks to Pat Somers of the Univ. of Arkansas at Little Rock and Art Bilski of the Illinois Student Assistance Commission for their assistance with this section.

Bankruptcy and Eligibility for Financial Aid

Will a bankruptcy affect a student's future eligibility for student loans and other financial aid?

The answer to this question is a complex one because several issues are involved. It depends on the nature of the student loan programs (federal or private) and the type of bankruptcy.

Whatever the circumstances behind the bankruptcy, the student should talk with the financial aid administrator at the school he plans to attend, and explain the situation. The financial aid administrator may be able to guide the student to certain loan programs or lenders that may fit his needs.

Federal Loans

Generally speaking, a bankruptcy should have no impact on eligibility for federal student aid.

A few years ago students who had their federal student loans discharged through bankruptcy were required to reaffirm the debt in order to be eligible for further federal student aid. But the Bankruptcy Reform Act of 1994 (P.L. 103-394, enacted October 22, 1994) amended the FFELP regulations dealing with loans discharged in bankruptcy. As a result of those changes, a borrower who had FFELP loans previously discharged in bankruptcy is no longer required to reaffirm those loans prior to receiving additional federal student aid.

Title IV grant or loan aid (including the Perkins loan program) may not be denied to a student who has filed bankruptcy solely on the basis of the bankruptcy determination. Financial aid administrators are precluded from citing bankruptcy as evidence of an unwillingness to repay student loans. Schools may nevertheless continue to consider the student's post-bankruptcy credit history in determining willingness to repay the loan.

As long as there are no delinquencies or defaults on student loans currently in repayment, the student should be eligible for additional federal student loans, regardless of any past bankruptcies. However, if some of the student's federal student loans are in default and were not included in a bankruptcy, the student will not be able to get further federal student aid until he resolves the problem. Students with loans in default should contact the lender (or servicer or current holder of the loan) to set up a satisfactory repayment plan in order to regain eligibility for federal student aid. (If the loan was discharged in bankruptcy after the borrower defaulted on the loan, it is no longer considered to be in default.)

Parents who apply for a PLUS loan may be denied a PLUS loan if they have an adverse credit history. The definition of an adverse credit history includes having had debts discharged in bankruptcy within the past five years. If this is the case, the parents may still be eligible for a PLUS loan if they secure an endorser without an adverse credit history. If the parents are turned down for a PLUS loan because of an adverse credit history, the student may be eligible for an increased unsubsidized Stafford loan.

Private Loans

Private loans are an entirely different matter. Because of the many different types of bankruptcies, this is a very complex issue.

The student should contact the financial aid administrator at his school for advice on the impact of a bankruptcy on eligibility for private loans. The student should also talk to the lender and provide evidence that he is a good risk, and be prepared to explain the circumstances behind the bankruptcy. The lender may be more willing to issue a loan if the borrower offers to secure the loan. If the student is still having problems, he may want to consult the attorney who handled the bankruptcy.

Most bankruptcies will have an impact on eligibility for private loan programs, including some school loan programs. Many private loan programs have credit criteria that preclude people with a bankruptcy within the past 7 or 10 years from borrowing without a creditworthy cosigner. There are, however, exceptions if the bankruptcy was initiated for reasons beyond the borrower's control, such as extraordinary medical costs, natural disasters, or other extenuating circumstances.

If a parent went through bankruptcy, it should have absolutely no impact on their children's eligibility for private loans, unless the parent is required to cosign the loans.

If the bankruptcy filing included a payout plan, even if not 100%, the student will be at an advantage in applying for private loans. Bankruptcy filers with a payout plan, especially a 100% payout plan, are a better risk than most people who have gone through bankruptcy. On the other hand, if the borrower went the Chapter 7 route, he may have more difficulty in getting a private loan. Lenders tend to look less favorably on complete liquidations. Thus borrowers who filed for a Chapter 11 (or Chapter 13) and had a payout plan will be more likely to get a private loan than borrowers who filed a Chapter 7.

Lenders also look at whether the borrower is able to refile for bankruptcy. Chapter 11 filers cannot immediately refile again for bankruptcy. Although any lender should know this, they may need to be reminded. Chapter 7 files are prohibited from refiling a Chapter 7 bankruptcy for 6 years. However, Chapter 13 plans have no such restriction, so a debtor can file a Chapter 7 bankruptcy, have their debts discharged, and then file a Chapter 13 within a very short time if new debt is incurred. A debtor can file an unlimited number of Chapter 13 bankruptcies. On the other hand, Chapter 13 filers are prohibited from filing a Chapter 7 immediately.

Nevertheless, lenders tend to be wary of Chapter 13 bankruptcies because a high percentage of them are converted to Chapter 7 cases or are dismissed because the debtor is unable or unwilling to continue with the payment plan established under the Chapter 13 repayment plan.

Discharging Student Loans Through Bankruptcy

Can educational loans, such as the Federal Stafford, Federal PLUS, and private loans, be discharged through bankruptcy?

Section 523(a)(8) of the US Bankruptcy Code, at 11 U.S.C., excepts from discharge debts for "an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution; or an obligation to repay funds received as an educational benefit, scholarship, or stipend; or any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the Internal Revenue Code of 1986, incurred by a debtor who is an individual" unless "excepting such debt from discharge under this paragraph would impose an undue hardship on the debtor and the debtor's dependents".

For the purpose of this paragraph, the definition of of a qualifying education loan includes loans made solely to pay the higher education expenses of an eligible student, where the student is either the debtor, the spouse of the debtor, or the dependent of the debtor. In addition, the loans must be for study at a school that is eligible to participate in Title IV programs and where the student is enrolled at least half time. Loans that don't meet this definition, such as credit card debt, are still dischargeable even if they were used to pay for higher education expenses.

Thus FFELP and FDSLP loans, and education loans funded or guaranteed by private nonprofit organizations, are automatically nondischargeable in a bankruptcy proceeding. The only cases in which they can be discharged through bankruptcy are:

if the borrower files an undue hardship petition

and then it is up to the judge to decide whether the loan can actually be discharged. (The Higher Education Amendments of 1998 repealed the provision that allowed for the discharge of education loans that had been in repayment for 7 years. This affects all bankruptcy proceedings initiated after October 7, 1998, regardless of whether they involve loans incurred before that date.)

Section 220 of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), P.L. 109-8, extended similar protections to "qualified education loans" starting on October 17, 2005, even when they are not funded or guaranteed by a nonprofit organization. Qualified education loans is defined to include any debt incurred by the taxpayer solely for the purpose of paying for qualified higher education expenses of the taxpayer, the taxpayer's spouse, or any dependent of the taxpayer. (Dependency is determined as of the time the taxpayer took out the loan.) Interestingly enough, most private student loan programs seem to have some sort of nonprofit involvement.

BAPCPA also made it more difficult to file under Chapter 7. If the borrower's income is above the median income in his/her state or is sufficient to repay 25% or more of his/her debt, the borrower will be forced to file under Chapter 13, which requires repayment over three to five years. BAPCPA also mandates credit counseling before a borrower can file for bankruptcy.

FinAid analyzed FICO score distributions before and after BAPCPA showing no appreciable increase in availability of private student loans. Some of this might be explained by the lenders believing that their loans were excepted even prior to BAPCPA. If so, why did the lenders push the BAPCPA changes based on arguments that it would increase the availability of private student loans?

It is worth noting that the extension of the bankruptcy exception to qualified education loans in 11 USC 523(a)(8)(B) cross-references IRC section 221(d)(1) for the definition of a qualified education loan. This section of the Internal Revenue Code requires the loan to be used "solely to pay qualified higher education expenses". IRC section 221(d)(2) defines qualified higher education expenses as:

The term "qualified higher education expenses" means the cost of attendance (as defined in section 472 of the Higher Education Act of 1965, 20 U.S.C. 1087ll, as in effect on the day before the date of the enactment of this Act) at an eligible educational institution, reduced by the sum of --

the amount excluded from gross income under section 127, 135, 529, or 530 by reason of such expenses, and
the amount of any scholarship, allowance, or payment described in section 25A (g)(2).

So to qualify for this exception, the private student loan must be capped at the cost of attendance minus student aid, such as scholarships, and expenses paid for using amounts from employer tuition assistance, 529 college savings plans and prepaid tuition plans, US savings bonds and Coverdell education savings accounts. If a borrower were able to show that the loan exceeded the limits set by IRC section 221(d)(2), they might be able to argue that the loan was ineligible for bankruptcy protection and so should be subject to discharge. See IRS Tax Topic 456 and IRS Publication 970 for further IRS guidance on what types of expenses qualify, such as the requirement that the expenses must have been "paid or incurred within a reasonable time before or after you took out the loan" (per IRC section 221(d)(1)(B). IRS Publication 970 provides a safe harbor of 90 days before and after the academic period to which the expenses relate. Consolidation loans and other loans used to refinance a qualified education loan also qualify, provided that there was no cash out from the refinance (or that the cash out was used solely for qualified higher education expenses). Eligible student is defined by IRC section 25A(3) as a student enrolled at least half time in a degree or certificate program at a Title IV institution (per Section 484(a)(1) of the Higher Education Act of 1965).

More details and other limitations on the exception to discharge can be found in Limitations on Exception to Discharge of Private Student Loans.

Most court cases cite Brunner v. New York State Higher Education Services Corp. (October 14, 1987, #41, Docket 87-5013) for a definition of "undue hardship". That decision adopted the following three-part standard for undue hardship:

That the debtor cannot both repay the student loan and maintain a minimal standard of living based on current income and expenses.
That this situation is likely to persist for a significant portion of the repayment period of the student loans.
That the debtor has made good faith efforts to repay the loans.

The first element of the standard usually involves evaluating what the monthly payment would be under Income Contingent Repayment, as opposed to standard ten-year repayment. Note that if the borrower has multiple student loans and could afford to repay some but not all of them, the court will generally discharge only those loans that exceed the borrower's ability to repay.

The second element of the standard requires the debtor to provide evidence of additional exceptional circumstances that are strongly suggestive of a continuing insurmountable inability to repay, such as being disabled or having a disabled dependent. A serious physical or mental illness might also qualify. The court also cited the debtor's failure to take advantage of forbearances and deferments. An inability to work in one's chosen profession does not necessarily preclude being able to work in another field.

Even if a loan doesn't come under the non-discharge provision for student loans under the Bankruptcy Code, the debtor's petition would still be reviewed and could be denied on various other grounds, such as abuse of the bankruptcy laws.

34 CFR 685.212 describes the conditions for discharge of a loan obligation under the federal direct loan program, and includes the following statement on bankruptcy:

(c) Bankruptcy. If a borrower's obligation to repay a loan is discharged in bankruptcy, the Secretary does not require the borrower or any endorser to make any further payments on the loan.

Page 2-32 of the Federal Student Financial Aid Handbook states:

A student with an SFA loan discharged in bankruptcy is eligible for SFA grants, work-study, and loans. Prior to October 22, 1994, a student whose defaulted loan was discharged in bankruptcy could not receive loan funds unless the student reaffirmed the discharged debt and made satisfactory repayment arrangements. Because of legislative changes made by the Bankruptcy Reform Act of 1994, the reaffirmation requirement was lifted. Students no longer must reaffirm discharged loans before receiving new loans. In addition, if a student has a loan stayed in bankruptcy, he or she remains eligible for SFA funds as long as he or she has no loans in default (including the stayed loan) and as long as all other eligibility requirements are met.

Regardless of whether the education loan is dischargeable, the debtor should consider objecting to the claim of the holder of the loan in a Chapter 13 proceeding. This requires the creditor to provide an accounting of the amount owed and any additional charges and fees that were applied to the loan balance. Often lender records are in a state of disarray (especially if the loan has been sold) and it will be unclear how much is actually owed. The burden of proof is on the lender, not the debtor (although it is helpful if the debtor has cancelled checks and other records of payments made). The judge will then decide the amount that is properly owed.

Types of Bankruptcies

This section provides a short glossary of the different types of bankruptcies. As noted above, bankruptcy does not relieve you of the obligation of repaying your student loans. It also does not affect child support and alimony payments, and income tax obligations.

Chapter 7: Complete liquidation of all personal assets to repay debts.
Chapters 11: Reorganization bankruptcy in which a plan is filed with the court to repay creditors. Chapter 11 is used for debts in excess of $1 million and is used mainly by businesses.
Chapter 12: A bankruptcy for family farmers.
Chapters 13: Reorganization bankruptcy in which a plan is filed with the court to repay creditors. Chapter 13 is used for debts under $1 million and is used mainly by consumers.