On June 30, the Supreme Court ruled that the Biden administration did not have authority to forgive student loans under the Higher Education Relief Opportunities for Students Act of 2003 (HEROES Act). Despite this defeat, the Biden administration is still working to reduce the burden of student loans. Advocates for student loan relief argue that student loans can be a crushing form of debt in part because of their treatment in bankruptcy. It is the common belief that student loans, unlike other forms of unsecured debt, are not dischargeable in bankruptcy. But a group of private student loan services was recently hit with a proposed consumer class action accusing them of wrongfully collecting more than $1 billion on student loans that had been discharged in bankruptcy.
So, what exactly happens to student loans in bankruptcy, and can borrowers get relief?
Under section 523(a)(8) of the Bankruptcy Code, a discharge of student loans is available, but only if the debtor can show an undue hardship. The term “undue hardship” is not defined in the Bankruptcy Code, but most circuits follow the Brunner[1] test. Under this test, a debtor must show (i) that he or she cannot maintain a minimal standard of living if forced to repay the loans, (ii) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period, and (iii) that he or she has made good faith efforts to repay the loans. A minority of courts follow the “totality-of-the-circumstances” test. Under this test, courts will consider the debtor’s (i) past, present, and future financial resources, (ii) reasonable, necessary living expenses, and (iii) other relevant factors and circumstances.
Some critics have pointed out that when Brunner was decided in 1985, student loans were non-dischargeable only for the first five years after they came due, so a showing of undue hardship was only needed if the debtor sought a discharge prior to that point. As such, the Brunner test, and its consideration of both future earning potential and good faith, was meant to prevent borrowers from abusing the bankruptcy system by seeking a discharge immediately after graduating, when their incomes are likely lowest. Now, the hardline test created in Brunner does not seem appropriate for adults who may be on the hook for their student loans years, or even decades, after graduating. In addition, the requirement of good faith, which generally requires consistent payments over a period of time, is often impossible to meet if the first two prongs of the test are present.
Critiques have also been lodged against the totality-of-the-circumstances test. Some observers have noted that, like the Brunner test, the final prong of the totality-of-the-circumstances test permits courts to consider a borrower’s good faith. In addition, some commentators note that a borrower’s past financial resources should be irrelevant, and the only consideration that should matter is the borrower's ability to pay in the present and future.
Regardless of which test is used, proving undue hardship is a high hurdle. Many courts essentially require utter hopelessness for repayment, and the few cases that have found undue hardship have involved extreme instances of mental or physical disabilities.[2]
But, not all types of student loans are treated equally under section 523(a)(8), which covers “an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit” and “any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the Internal Revenue Code of 1986.” Therefore, government student loans automatically fall under the purview of section 523(a)(8), but private loans only fall under section 523(a)(8) if they meet the definition of “qualified education loan” set forth in section 221(d)(1) of the Internal Revenue Code of 1986.
Section 221(d)(1) of the Internal Revenue Code of 1986 contains several requirements. For example, the loan must be used to pay “qualified higher education expenses,” which are limited to the cost of attendance at an “eligible educational institution” minus any scholarship or other allowance. As a result, any portion of a private student loan beyond the cost of attendance, such as living expenses, is not a qualified education loan and is fully dischargeable in bankruptcy. In addition, given the definition of “eligible educational institution,” loans used for attendance at unaccredited schools or trade programs would be fully dischargeable as well.
There are some other important limitations to the definition of “qualified education loan” that may help borrowers obtain some relief, but the most helpful part of this distinction is that it puts the burden on private lenders to prove that their loans fall under section 523(a)(8). So, while a borrower seeking to discharge a government loan must assert undue hardship by commencing an adversary proceeding, a private lender must commence a legal action in order to get the benefit of section 523(a)(8).
Still, very few student loans are actually discharged in bankruptcy. This may be in part because most borrowers don’t even try, but the recent class action mentioned above demonstrates that even when a discharge is received, borrowers may not be free from collection attempts. Therefore, although the statement “student loans are non-dischargeable in bankruptcy” is woefully oversimplified, the reality is not much better.
[1] See Brunner v. New York State Higher Educ. Servs. Corp., 831 F.2d 395 (2d Cir. 1987).
[2] See In re Smith, 582 B.R. 556 (Bankr. D. Mass. 2018) (debtor suffering from epilepsy that led to various affective disorders and eventual psychiatric hospitalization).
