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What Happens to Student Loans in Bankruptcy?

Bankruptcy discharge is a powerful tool, but does it erase a debtor's student loan debt?  Rarely.  In most instances, the obligation remains to repay student loans despite filing Chapter 7 or Chapter 13 bankruptcy. In the most limited occasions, a debtor is able to meet the stringent test for establishing an undue burden in having to repay the student loan and is found to be eligible to receive a hardship discharge, which eliminates the student loan.

Automatic Stay

Notwithstanding the inability of a debtor to completely discharge the student loan by filing bankruptcy, there are some impacts of filing bankruptcy on student loans. For instance, during the bankruptcy case, the debtor is exempt from collection on the loan. The automatic stay that immediately goes into effect upon the filing of the bankruptcy petition prevents collectors from taking any action against the debtor to collect.

Impact on Interest

However, the student loan does not just freeze solely because a bankruptcy has been filed. Interest continues to build, even during the pendency of a bankruptcy. As a result, the ultimate balance for a student loan is higher with additional interest.

In some situations, even though the student loan's principal is not dischargeable in bankruptcy, it may be possible for interest on the loan to be excused. The type of bankruptcy filed (as well as other factors) assists in making the determination of whether interest is forgiven. Chapter 7 and Chapter 13 bankruptcies treat student loans differently.

Student Loans Under Chapter 7

In a Chapter 7 bankruptcy, a debtor's assets are sold, and debts are paid from sales proceeds in accordance with a priority system of seniority. The priority scheme is set in the bankruptcy code and based upon the order of liens, rather than preferences of the debtor. The most senior debts may be the only debts repaid due to the larger number of debts compared to asset sale proceeds. Student loans are often classified as senior debts and are paid in first priority.

Student Loans Under Chapter 13

In Chapter 13, debtors enter into a reorganization plan and make payments over several years to repay a percentage of total debts. The Chapter 13 plan establishes new terms for the repayment of debts, and lenders must consent to the plan's terms. While a complete discharge of a student loan is nearly impossible, it is probable that the loan will be restructured through the bankruptcy plan, and the borrower's payments each month will be lowered to a more affordable sum. A deferment or period of freezing the loan without requiring payments to be made on same might be possible during a period of unemployment. It may also be possible to have fines and penalties on the loan for late or missed payments to be removed.

While it would be nice to have Chapter 7 or 13 bankruptcy eliminate outstanding student loan debt, total discharge of that debt seldom occurs.  More often, student loans are paid first as senior debts or paid through installments in Chapter 13.