STUDENT LOANS AND BANKRUPTCY Lesson 1: Uncle Sam Comes First

Education, in the form of short-term vocational programs to graduate or professional curriculums, refers to the attainment of knowledge and skills that enable the next generation to become productive, contributing members of society. Although nowhere in the world is education more valued than in this country, the cost of education has transformed this fundamental building block of modern society into a luxury. In recent years, total educational debt has surpassed all other forms of consumer debts except home mortgages, prompting many to forecast educational debt as the forerunner for the next debt crisis. Aside from the rising cost of education, the borrowing rate has also soared since the Great Recession. This debt burden has, in turn, erected new barriers for newly-minted graduates to participate in the credit market.

The rapid rise in educational borrowing is closely followed by double-digit increases in student loan defaults. The federal government has provided borrowers with some safe haven from a life-long debt shackle, in the form of consolidation or forgiveness programs.  However, many such programs force borrowers to endure the same stringent conditions as that of a Chapter 13 bankruptcy debtor. Repayment plans typically last 2 to 5 times as long as the average Chapter 13 plan, and the amount forgiven (if any) at completion is still taxable as income.

Despite the limited nature of relief provided under government consolidation and forgiveness programs, borrowers should consider them first for a few reasons: (1) the cost-benefit analysis, compared to more expensive and riskier debt relief mechanisms – e.g., litigation or bankruptcy; (2) the government’s ability to expeditiously seize income and tax attributes without a formal court action; and (3) the proportion of total debt that government debt typically occupies in the average student borrower’s portfolio. Indeed, the importance of prioritizing federal loans in any repayment plan cannot be understated. Federal loans now constitute approximately 85% of all outstanding educational debt, and 93% of new loans. Unlike private loans, these loans are made without regard to student creditworthiness. More importantly, collection charges, upon default, can constitute over 19% of the repayment. This is equivalent to a payoff amount that adds nearly a 25% to the balance of the loan.  Additionally, credit diminution will hinder the student borrower from obtaining other forms of credit, not to mention the negative effect on housing or job applications.

Under standard repayment programs, the borrower pays a fixed amount of at least $50 per month for 10 years. This provides for the shortest repayment period, but the highest monthly amount. Borrowers with high loan balances may extend the repayment term, which may be either fixed or graduated, through consolidation. Consolidation terms range from 10 to 30 years.

Students struggling to meet standard repayment criteria may apply for Income Contingent Repayment (ICR) programs. The monthly ICR payment is calculated each year based on adjusted gross income of the borrower and her household, but capped at 20% of the borrower’s discretionary income. If the income is not sufficient to cover accumulated interest, the interest is capitalized once a year. However, capitalization will not exceed the original amount owed when the borrower entered into the repayment program; interest will only continue to accrue without further capitalization. The repayment period is also capped at 25 years, and any unpaid portion is forgiven at the end of the ICR term.

Alternatively, a student debtor might consider an Income Based Repayment (IBR) program. In order to qualify, borrowers generally must have a loan balance that exceeds their annual gross earnings. Payment under the IBR program is capped at 15% of the borrower’s adjusted gross income exceeding 150% of the state poverty level. Borrowers that earn below 150% of the state poverty level may stay current without any payment. Borrowers become recertified based on their adjusted gross income and household size every year. As with ICR programs, forgiven debt is potentially taxable as income. For low-income borrowers with legacy Federal Family Education Loan (“FFEL”) Program loans who do not qualify for IBR programs, Income Sensitive Repayment Plans provide reduced payments based on an income formula for a period of up to 10 years.

For newer borrowers (those who received their first disbursement of federal student loan after October 1, 2011), there is a Pay-As-You-Earn Repayment (PAYE) program. Borrowers may qualify if their annual gross income is below total loan balance. The monthly repayment is capped at 10% of discretionary income and any amount remaining unpaid after 20 years is forgiven.

ICR, IBR and PAYE may be augmented with the Public Service Loan Forgiveness program, which grants loan forgiveness to public employees who have made 120 qualifying payments or maintained a 10-year fixed payment schedule. This supplemental option provides the additional benefit of non-taxable debt forgiveness. There is also a host of specialized loan forgiveness programs aimed at members of particular profession and/or special classes (e.g. teachers, veterinarians, lawyers, military personnel, disabled individuals).

Repayment programs should never be confused with non-permanent solutions such as deferment or forbearance programs. Although such programs allow the borrower to pay later and avoid immediate default, they do not help relieve the ultimate debt burden. As to forbearance programs, interest continues to accrue during the forbearance period and is typically capitalized at the end of the term. Settlement options are available to pay off large debts, but come as a rare luxury available only to borrowers able to make a sizable down payment and/or high installment payments paid over a short time span.

It is essential for student borrowers to explore the full panoply of repayment options for federal government loans before resorting to more drastic measures such as litigation or bankruptcy. Although there are various options available in both Chapter 7 and Chapter 13 bankruptcies for student borrowers, which will be explored in future blogs this month, a borrower’s efforts to seek out repayment alternatives will also better the borrower’s chances to discharge the educational debt in bankruptcy. This is yet another compelling incentive to explore all the options available and be creative when it comes to managing your financial life.

-Michael Li, Esq.

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