The Non-dischargeability of Private Student Loans: a Looming Financial Crisis?

• Jurisdiction: United States,Federal
• Publication year: 2015
• Citation: Vol. 32 No. 1

The Non-Dischargeability of Private Student Loans: A Looming Financial Crisis?

Preston Mueller

THE NON-DISCHARGEABILITY OF PRIVATE STUDENT LOANS: A LOOMING FINANCIAL CRISIS?

Abstract

In 2005, Congress altered 11 U.S.C. § 523(a)(8) to exclude private student loans from discharge in bankruptcy. The change was a line-item in a larger bankruptcy bill, but it has had massive effects on the higher education market in the United States.

This Comment will show how granting private student loans the privileged status of being non-dischargeable in bankruptcy skews lenders' incentives. Because private student lenders know that their debts cannot be discharged, they have no incentive to consider a student borrower's ability to repay. As a result, most students are granted a nearly unlimited line of credit without lenders worrying about those students' ability to repay. This Comment argues that this phenomenon has thus led to skyrocketing university tuition rates in the past decade, which in turn has created the need for students to borrow even more. This troubling cycle is creating a bubble in the higher education market, which will have disastrous effects if left unaddressed.

This Comment will also propose a solution to this problem. By allowing students to discharge private student loans in bankruptcy, Congress could create a self-sustaining mechanism in the private student loan market by restoring lenders' incentives to gauge students' ability to repay. If Congress changes the Bankruptcy Code to allow private student loans to be discharged in bankruptcy, lenders will only grant loans proportionately to a student's ability to pay. This Comment ultimately argues that this small change will have far-reaching and highly beneficial results for the nation's economy.

[Page 230]

Introduction

In the fall of 2015, roughly 20.2 million students were expected to attend colleges and universities across the United States, constituting over 4.9 million more students than in the fall of 2000.¹ Between 2002 and 2012 alone, college enrollment in the United States increased by 24%.² Not only are more students attending college, but they are paying a higher price for this education than ever before.³ controlled for inflation, the average four-year private university tuition in 1974 was $10,273, measured in 2014 dollars.⁴ By 2014, this average figure had risen to $31,231, an increase of roughly 204%.⁵

The historical increases in college enrollment and tuition rates have made financing higher education big business in the United States.⁶ Student loans are the second-highest form of consumer debt facing our nation behind mortgages, accounting for $1.2 trillion of debt.⁷ The average student graduating in 2012 owed $29,400, which is over $10,000 more than the average student debt just ten years ago.⁸ Legislatures have taken notice of this explosive rise in debt and are proposing legislation to help distressed student loan debtors find a way out of their predicaments.⁹

Of special interest to this Comment are the changes to the Higher Education Act proposed by Senator Tom Harkin, one of which would allow

[Page 231]

debtors to discharge all private student loan debts in bankruptcy.¹⁰ Under the current system, discharging any student loan is difficult and can only be done in rare instances where the debtor can show that keeping the debt will cause an "undue hardship."¹¹ Because student loan debts are so rarely discharged in bankruptcy, private lenders have less incentive to worry about the ability of borrowers to repay and will grant students nearly infinite lines of credit for higher education.¹² This effect can be seen in the number of outstanding private student loans over time.¹³ Until the 2005 amendments, private student loans were dischargeable under the Bankruptcy Code (the "Code").¹⁴ In 2005, when private student loans were first exempted from discharge, $6.6 billion in private student loans were granted by lenders.¹⁵ This number jumped to $7.8 billion the next year, and was above $10 billion by 2008.¹⁶

The fact that the private student loan industry saw a 50% increase in the years immediately following a change in the Code pertaining to private student loans is likely no coincidence. Thus, it seems that the exemption of private student loans from discharge is at least partially to blame for the spiraling cost of college tuition and the ballooning level of student loan debt seen in the United States. In order to fight the negative effects of this amendment, Congress should follow Senator Harkin's suggestion and allow private student debts to be discharged in bankruptcy as they were before the 2005 amendments to the Code.¹⁷

[Page 232]

I. Background

A. Statutory Background

Student loans were not always exempt from discharge in bankruptcy.¹⁸ In fact, prior to 1976, all student loans were eligible for discharge in bankruptcy.¹⁹ In 1976, Congress changed this policy by enacting § 439(A) of the Higher Education Act of 1965.²⁰ This Act mandated that student loans would be exempt from discharge in bankruptcy unless: 1) they became due more than five years before the date of filing, or 2) exempting the discharge would cause an "undue hardship" on the debtor and his dependents.²¹ The reasoning behind Congress's decision to exempt federal loans was largely due to a desire to protect the solvency of the federal student loan program from the perceived abuses of bankruptcy discharge.²² Congress's fear of rampant student loan debt abuse was largely based on anecdotal evidence.²³ At the time, there were stories circulating about students getting "free" educations by discharging their student debts upon graduation without trying to make any repayments or showing extenuating circumstances.²⁴ Despite Congress's fear, empirical studies conducted recently have found that when the Higher Education Act was enacted, less than 1% of all federal student loans were discharged in bankruptcy.²⁵ Clearly, Congress's fears were unfounded, and the abuse of student loan discharge was too minor to threaten the federal student loan program in any way.²⁶ Yet, over time, more and more forms of student debts have become exempted from discharge under this same guise of preventing abuse.²⁷

[Page 233]

The original Bankruptcy Code enacted in 1978 officially codified the student loan exemption from the Higher Education Act at § 523(a)(8).²⁸ Section 523(a)(8) exempted the discharge of any debt "to a governmental unit, or a nonprofit institution of higher education, for an educational loan," unless the loan first became due five years before filing for bankruptcy, or excepting the debt from discharge would impose an "undue hardship" on the debtor and the debtor's dependents.²⁹ In 1979, this language was amended to exempt from discharge any "educational loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or a nonprofit institution of higher education."³⁰ Yet another round of amendments in 1984 removed the wording "of higher education," effectively exempting from discharge all non-profit student loans, regardless of who made the loan.³¹ The time frame after which an individual could discharge student loans under § 523(a)(8) increased from five to seven years in 1990.³² Then in 1998, Congress changed the wording once again to abolish the discharge after seven years exemption, leaving the "undue hardship" exception as the only way to discharge student loans covered by § 523(a)(8).³³

Perhaps the largest change to the Code came recently in 2005, when Congress added § 523(a)(8)(B) which exempts private student loans from discharge.³⁴ These 2005 amendments were the most recent change to § 523(a)(8) and resulted in the current statute.³⁵ Under the current provisions, unless there is a showing of "undue hardship," discharge does not apply to:

[A]n educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution; or an obligation to repay funds received as an educational benefit, scholarship, or stipend; or any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the

[Page 234]

Internal Revenue Code of 1986, incurred by a debtor who is an individual.³⁶

Under this wording, all forms of student debt, public or private, are exempt from discharge in bankruptcy, absent a showing of "undue hardship."³⁷ The reasons given by Congress for the 2005 amendments to the Code were to ensure that "the system is fair for both debtors and creditors" and to "respond to many of the factors contributing to the increase in consumer bankruptcy filings . . . to eliminate abuse in the system."³⁸ Although the goal of the amendment was to eliminate abuse, many critics, including Senator Richard Durbin, argued no evidence existed to suggest that private student loan debts would be subject to abuse at a rate higher than any other consumer debt.³⁹ Not only is there scarce evidence of student loan abuse, but the private student loan industry had been growing before the 2005 amendments, making it hard to believe that abuse was threatening the industry.⁴⁰

The change exempting private student loans from discharge instead seems to be the result of a "sweetheart deal" between Congress and the private student loan industry.⁴¹ Critics believe that the facts surrounding the passage of the 2005 amendments support the conclusion that this amendment was snuck into a larger education reform bill.⁴² Specifically, the section which proposed the change to § 523(a)(8) was just seven lines amidst a vast multi-hundred-page bill.⁴³ In addition, in all of the dissenting opinions given in response to the proposed 2005 changes, there was not a single mention of the change to § 523(a)(8).⁴⁴ This lack of concern is especially peculiar because there were multiple House members who expressed...