An Escape Route on the Horizon for Student Loans
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UPDATED: Aug 3, 2012
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Private student loans are the bane of many borrowers, especially when compared to the more consumer-friendly federal student loans. While neither federal nor private student loans can be discharged through bankruptcy, private loans almost always carry higher interest rates and harsher late penalties.
Even if students compare student loan quotes online before borrowing, the fact that private college loans carry such high repayment terms and aren’t dischargeable through bankruptcy is having a major impact on our jobless graduates.
But regulators have begun to take notice of that impact.
A recent report by the Consumer Financial Protection Bureau (CFPB) and the Department of Education suggests that Congress should revise bankruptcy laws in the face of the ongoing recession. These revisions would include the option for borrowers to have their private student loans be terminated through bankruptcy proceedings.
The Downside of Bankruptcy
While no one—even indebted students—ever hope to file for bankruptcy, it can be a necessary evil for many.
The effects of bankruptcy are never pleasant. With bankruptcy come higher interest rates for future financing opportunities—that is, if bankrupt borrowers even qualify for a loan.
Bankruptcy consequences even follow borrowers to their personal lives. Some employers frown on applicants with bankruptcy histories, and reports of friends and family scoffing at bankruptcy filings are not all that uncommon.
What’s more is that these effects don’t just last for a few weeks or months. The black mark of bankruptcy stays on credit reports for up to a decade.
The Medicine of Bankruptcy
Despite those downsides, current and former students with debt and dismal job opportunities might consider bankruptcy if laws were changed to help them. This is particularly true considering that some have debt in excess of several hundred thousand dollars.
“The issue has gained a lot of attention and support as people become more aware of how different and more dangerous private loans are compared to federal loans, and how little recourse private loan borrowers have if they hit hard times,” said Lauren Asher, president of the California-based Project on Student Debt, in a Baltimore Sun interview.
Prior to the 1970s, both private and federal loans were able to be terminated through bankruptcy proceedings. Unfortunately for many today, Congress made federal loans restricted from bankruptcy in the ‘70s, and later made nonprofit agency loans exempt from bankruptcy in the 1980s. To take advantage of this change, many lenders became nonprofit in order to make their loans invulnerable to bankruptcy.
Today, only a very potent legal argument of “undue hardship” can cause a student loan to be discharged.
A recent—and rare—example was when a Baltimore judge discharged $340,000 in student loans. The borrower won this ruling after being physically disabled with a disorder that prevented her from regular employment.
The Truth May Be in the Middle
Interestingly, the CFPB and Education Department’s report failed to find any benefit to consumers as a result of the 1970’s bankruptcy changes for student loans.
Understandably, lenders are not pleased about the possibility of bankruptcy changes to their currently non-dischargeable loans.
“We made a contract with students to repay their loans and that’s how the banking system operates,” said Richard Hunt, president of the Washington-based Consumer Bankers Association.
Hunt predicts that there will be a rush of bankruptcy filings for private student loans if rules change. He also predicts that should laws be changed and banks continue to lend private student loans then, “there is no question [students] will get an increase in interest rates.”
Offering a middle-of-the-road approach, Sallie Mae has supported a bankruptcy option but only after payments have been made for five to seven years.
Desperate—or shrewd—new grads with high debt and limited assets could theoretically file for bankruptcy shortly after graduating. Sallie Mae’s President, Jack Remondi, reminded a congressional hearing that this theoretical situation—which is quickly becoming a “probable” scenario—was precisely the reason that student loans became exempt from bankruptcy to begin with.
Sallie Mae argues that if private loans should become dischargeable through new bankruptcy laws then so too should federal student loans since the financial difficulty graduates face does not hinge on whether their loans are federal or private.
Awaiting the Future
Despite Sallie Mae’s argument, financial difficulty is indeed more prominent with private student loans.
Borrowers in debt and without a job have several options, provided they are borrowers of government-backed loans. They can apply for deferrals, forbearance, and repayment flexibility. There is even a path for public service workers, such as educators, to obtain loan forgiveness.
Private lenders brutally refuse to offer any sort of options.
“That is the main case why private loans should be discharged,” said Mark Kantrowitz, publisher of FinAid.org.
Kantrowitz said that if lenders knew that student loans borrowers could file for bankruptcy then lenders would be far more eager to work with borrowers.
Private loans also house a less-known downside. They lack the interest rate caps that federal student loans have. It’s these private financing options that are almost completely to blame for recent news stories of the countless borrowers with debt over $100,000.
Case in point is the story of Katherine Lord from Milwaukee. She accrued $140,000 in student loan debt while going to law school—nearly all of which were private.
“Maybe I didn’t do as much research as I should have,” she said in a Baltimore Sun interview. “At the time, there just wasn’t great counseling on whether or not to take out private student loans.”
Lord attended law school in 2005—a few short years before the devastating recession—in Indiana before moving to Washington for employment. While her job prospects in Washington didn’t meet her expectations, her bank generously deferred her private loan payments for six months. However, once the deferment period ended, her monthly payments revealed themselves at over $800—more than her monthly rent.
Despite eventually finding temporary employment, the tidal wave of the recession swept away Lord’s job. She has been unable to find work since, and now, at age 34, she has been forced to move back in with her parents. While this former law school grad has managed to repay her $15,000 federal loans, her parents were forced to refinance their home to help make her private loan payments.
Lord believes that a bankruptcy option would give much needed help to borrowers who are trapped by private loans.
“If it had been an option, I know I would have considered it,” she said. “I understand just how drastically bankruptcy would affect my life, but at least I would be the one primarily affected, not my parents.”