There’s a myth going around that even if you declare bankruptcy, you still have to pay our student loans. This just isn’t true. You can have your federal student loans discharged in bankruptcy if you file an adversary proceeding, which means a court finds repayment of your student loans to cause undue hardship to you and your dependents. But how does bankruptcy work and is it a smart decision?
How Does Bankruptcy Work?
Bankruptcy is a court proceeding whereby a judge and a court trustee determine if your debts should be discharged because you can’t afford to pay them any longer. They’ll examine your assets and liabilities in order to reduce, restructure or eliminate your debt. Bankruptcy can carry long-term penalties because it stays on your credit report for 7 to 10 years.
The biggest benefit of bankruptcy? A clean slate. Although it can take six months or more to complete, you will feel the burden lift off your shoulders because you are officially debt-free.
One caveat, though, is that bankruptcy eliminates some of your debt, but it won’t eliminate all of it. Credit card debt can be eliminated through Chapter 7 and Chapter 13. Sometimes Chapter 13 can help with child support, tax debt, student loan, and secured debts.
How Does Chapter 7 Bankruptcy Work?
If you file for Chapter 7 bankruptcy, you need to know what will happen to any property that you own. Chapter 7 can wipe out all of your debt, but some debts won’t be erased. Chapter 7, which is also known as liquidation bankruptcy, enables you to keep “exempt” property. This all depends on the state you live in and can be anything from your entire home to only $5,000 in equity in your home.
Filing Chapter 7 includes steps such as going to credit counseling, hiring an attorney, taking the means test, completing paperwork, and more. It’s a lengthy and complicated process that requires patience and diligence.
How Does Chapter 13 Bankruptcy Work?
In Chapter 13, you can keep your property and repay debts through a repayment plan for up to five years. The amount that you pay depends on whether you have secured or unsecured debts. You usually pay only some of your unsecured debts via the plan and the rest is discharged. The law will give higher priority to certain debts meaning you have to pay those off first.
A Chapter 13 can stop a mortgage foreclosure. This means that the lender will have to accept a plan in order for you to make up for payments that you missed. It will also allow you to keep the property. Also, you are able to “cram down” secured debts in which you owe more than what the property is worth. For example, if you owe $15,000 on a car that worth only $5,000, you can “cram down” the amount owed to $5,000 and have the $10,000 discharged. This doesn’t apply if you bought the car within 30 months before you filed for bankruptcy.
What Can Bankruptcy Do?
Bankruptcy can be a powerful tool for some people drowning in debt, because it can:
- Eliminate credit card debt. A credit card balance is an unsecured debt, which means the lender doesn’t have collateral and cannot repossess any assets if you don’t pay it. Filing Chapter 13 means you might have to pay back some of your unsecured debts through a payment plan.
- Stop creditors from harassing you. If a creditor is going to repossess your car or foreclose on your house, then bankruptcy can help you. If you need to stop phone calls and letters, you can do that in other ways.
- Get rid of certain kinds of liens. A lien is a legal right that acts as a guarantee for repayment of a loan. If the obligation to pay is not met, then the creditor can take the asset that the lien stands for.
What Can’t Bankruptcy Do?
Bankruptcy isn’t a cure-all, because it cannot:
- Prevent repossession of property for failure to pay secured debt. Bankruptcy doesn’t eliminate liens, so a creditor can repossess your asset that stood in for the lien.
- Eliminate your obligation to pay child support. In addition to alimony, child support survives bankruptcy.
- Eliminate most tax debts. It’s very hard to erase tax debts through bankruptcy. It can sometimes be possible if the debts are for unpaid income taxes from long ago.
- Erase all debts including debts owed related to personal injury or death caused by drunk driving and fines for violating the law.
How Does Bankruptcy Work With Student Loans?
The law states that the court must find that a student loan would cause undue hardship in order for it to be discharged through bankruptcy. This can be a difficult process. A judge determines if your situation qualifies as undue hardship and often use the Brunner Test, which is a way to look at the totality of your circumstances.
What is the Brunner Test?
The Brunner test shows that under undue hardship, the person in debt shows that he cannot maintain a “minimal” standard of living for himself and his dependents if he continues repayment and that additional situations exist showing that this state of affairs will continue for a long period during the repayment of the loan. You must also show that you tried to pay the loans back.
When Not to Pursue Bankruptcy For Your Student Loans
If you have student loans and are thinking about bankruptcy, here are a few instances when bankruptcy isn’t a smart move:
- If you have other ways of discharging your loans such as with forgiveness programs. Public Service Loan Forgiveness, for example, will discharge your unpaid balance after 120 timely monthly payments. This is tax-free and not nearly as complicated as bankruptcy.
- If you can’t prove undue hardship. Under the law, you need to be able to prove that repaying your loans would cause undue hardship to yourself and your dependents.
- If your income is low, consider an income-driven repayment plan. Payment in an IDR can be as low as $0.00 per month and can last the entire life of the loan if your income stays the same. Also, after 20-25 years of ayment in an IDR, the loans are completely forgiven.
Think Carefully Before Seeking Student Loan Bankruptcy
There’s a lot of misinformation about bankruptcy and how bankruptcy works, which can make it confusing if you’re seeking answers related to your situation. Carefully assess what route is right for you, whether it be by consulting a lawyer, financial adviser or researching other options available to you. If you feel like paying back your student loans is too much and you need help, then find a resource you trust and you’ll soon be able to get back on track.