How Bankruptcy Can Rescue Students from the Debt Trap

September 2nd, 2010 at 12:54 pm | 9 Comments |

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Higher education is expensive.  This is not surprising because of the inherent costs incurred by education providers that need to be passed on to their consumers and because higher education is a valuable good.  That having been said, increases in tuition rates have outstripped the rate of inflation in recent years, which has fed a rise in the amount of student loan debt that undergraduates have incurred to fund their educations.  Recently, this issue has received increased attention and it merits a public policy response, particularly because attaining an undergraduate degree is a prerequisite for merely entering into the labor force at a certain level.

Here are some basic facts gathered from a recent report from the Pew Charitable Trust’s Project on Student Debt and from a 2006 report from the American Association of State Colleges and Universities:

  • In 2008, 62% of graduates from public universities had student loan debt, 72% of graduates from private non-profit universities had student loan debt and 96% of graduates from private for-profit universities had student loan debt.
  • Average student loan debt burdens increased 24% from 2004 through 2008.
  • In 2008, at public universities the average debt was $20,200 (20% higher than 2004), at private non-profit universities the average debt was $27,650 (29% higher than 2004) and at private for-profit universities the average debt was $33,050 (23% higher than 2004).
  • In 2006 the average graduate from a state university owed $17,250 in loans, when ten years before the amount was (adjusted for inflation) $8,000.
  • These numbers actually understate the problem, because they do not include all private (non-federal) loans that students carry.  Also, usage of credit cards or other forms of debt to pay for student living expenses are not included here.

Such debt inherently limits the freedom of students to choose the sorts of majors or activities they might otherwise want to participate in, because of the need to get a degree and to build a resume that is geared towards finding a job that can pay for student loan debt.  Furthermore, such debt burdens create long-term economic hardships for new graduates by lowering their disposable income and their standard of living, limiting their career options and career mobility (which is not beneficial from an efficient labor market standpoint), and by making it more difficult for them to save for a home, retirement or their own children’s educations.  Also, it has been suggested that such debt creates a disincentive for young people to marry and have children.

Given all these issues, what can be done from a public policy standpoint?  There has been recent activity on this through legislation signed into law by the Obama Administration to increase Pell Grants, to eliminate fees paid to private banks to act as loan intermediaries, and to cap repayment levels above a certain minimum income and living allowance level.  Also, under this legislation, loan balances will be forgiven for people who keep up their payments and are involved in public service work, including military service.

These are all good steps, but I’d suggest one more that can be taken.  Another public policy step would be to allow student loan debt to be dischargeable in bankruptcy.  Such debt currently is not dischargeable, except in rare circumstances, and this creates the current problem of people who are essentially bankrupt being forced to continue with this loan debt.  The obvious response is that if we allow discharge, this will make it harder for some students to get loans because lenders will see them as a higher risk because of the ability to discharge.  That may not be such a bad thing.  While we want to maintain loan opportunities and not shut out students from the student loan market, there needs to be some sort of balance and realism injected into the process.  One may certainly argue that it does no one any good for students to be provided tens of thousands of dollars in government-supported non-dischargeable loan debt for schooling situations that, under the cold light of a lender’s analysis, are unlikely to provide the sort of income that would justify large-scale debt.  It is true that for some students, such an analysis may mean they don’t get a loan, but this may not be the worst thing in the long run, particularly in light of recent experiences in our economy with other kinds of debt.

There are two other possible objections to allowing discharge of student loan debt that should be noted here.  The first is that allowing discharge might encourage more young people to declare bankruptcy.  While this is a possibility, one should remember that bankruptcy is a harsh remedy and as such one shouldn’t assume that young debtors would seek it out as anything other than a last resort.  Further, if lenders become more careful in vetting debtors because of the possibility of discharge, presumably this would mean the pool of debtors that receive such loans would be less likely to become overextended.  The other objection relates to fairness, namely the justification for allowing discharge of student loan debt when other obligations, such as child support payments or back taxes, generally are not dischargeable.  I would suggest that student loan debt is similar to other forms of loan debt which are dischargeable, and fairness would dictate treating it like such other debt.  Also, student loan debt differs from obligations that either arise from the need to support children and prevent them from becoming dependent on the state (like child support) or that arise from basic legal requirements of society (like paying taxes).

The current student loan system has serious incentive problems and consequences.  Qualified students should not be discouraged from seeking higher education and the student loan market provides a necessary service for financing such education.  However, some policy changes should be made to avoid making a legacy of large-scale debt to banks or the government an inevitable part of higher education.

Recent Posts by Mark R. Yzaguirre

9 Comments so far ↓

  • Oldskool

    We should nationalize the banks, the health care system and everything else. Capitalism turned loose and running amuk has created an entire generation of debtors. Example: when credit cards were first invented they were considered a scam to be avoided. Now, every business uses the very same model and their response to the mess of debtors they created was to storm Congress and write a newer, more stringent bankruptcy bill.

  • Rabiner

    Umm, if you’re poor and after college can just declare bankruptcy why would universities ever give you loans in the first place? That makes zero sense if you’re goal is to make college more accessible to people.

    Also tuition has increased faster than inflation for public universities and colleges because States have been forced to cut back on publicly subsidizing these institutions and thus must make up the difference in higher tuition to students.

  • JeninCT

    “The first is that allowing discharge might encourage more young people to declare bankruptcy. While this is a possibility, one should remember that bankruptcy is a harsh remedy and as such one shouldn’t assume that young debtors would seek it out as anything other than a last resort. ”

    I disagree. Bankruptcy to a young person with no assets will seem very appealing. Once it’s available, watch the ads spring up for lawyers eager to assist young grads with all the pesky details.

  • Claude

    There’s a reason student loans can’t be discharged. Before, people were going to medical school, declaring bankruptcy after their last tuition payment, and then earning a lot of money with all their student loans conveniently gone. You want to bring that back?

  • llbroo49

    Perhaps you could allow student loans to be discharged via bankruptcy, however a lot stipulations would have to be enacted. Examples would be:

    *Requirements to be current on student loans for X amount of years before they are eligible for discharge.

    *Determinations of future earning potential in certain education/ career fields. For example a graduate from a law program who is consistently unable to pass the BAR will not have the same earning potential as anticipated at the outset of pursuing a law degree.

    Other solutions could be allowing students to write off all student loan payments (not just the interest) against tax liabilities.

    Or expanding career fields that are eligible for student loan forgiveness, particular in fields that are undermanned and are productive to society overall.

  • CO Independent

    This is a well written article, Mark.

    The big problem with permitting discharge of student loans in bankruptcy is that it will drive private capital out of the student loan market unless the loans are guaranteed by the government. Frankly, several of Obama’s plans will do the same thing.

    A market rate for an unsecured loan that is dischargeable in bankruptcy to a young person with no real credit history is more like 25-30% than the 8% students pay on loans. Private capital will sit this one out unless the government guarantees losses.

    I see you are an attorney. So am I. I do not practice bankruptcy law, but I have a recollection of the general contours of the law from law school. As I recall, bankruptcy stayed on your credit record for 7 years. If that is still the case then I would advise any young college graduate with significant student loan debt to file for bankruptcy immediately upon graduation. They could discharge their debt and the blemish would be off their credit record by the time they are 30. They might as well run their credit cards up and buy a new car before they file too.

    I’m not sure this is such a great idea.

  • JonF

    Perhaps student loans should have a bankruptcy-exempt period so people couldn’t just file on graduation before they get a job. For back taxes it’s three years before they be discharged in bankruptcy. Maybe five years would be adeqeuete for student loans?

  • JeninCT

    I think the Obama administration’s takeover of student loans might just be the first step in state sponsored college. Call me crazy but it makes sense, especially when he’s been talking about allowing grads to only pay a certain percentage of their income toward college loans, and that certain loans could be forgiven. I remember him discussing something like this awhile back, and it wouldn’t surprise me in the least if that was the goal somewhere down the road.

  • yvonnene1

    I personally took out a private loan to finish my education. It started out as something affordable , then the loan was taken over my another finacial institution my repayment plan is now over 700$ a month. The new company has informed me, I have used all my options for forberence and defferments and they won’t work with me at all for any type of lower payment options . I know that legally I signed these papers with a co- signer for this loan however I feel trapped and she has three kids and a house and can’t afford this, my rent alone is 650$ a month. I dont make much more than those two combind. I don’t know if filing bankrupcy is even an option to cover the loans???? They said if I paid off the loan today the amount in full would be to the tune of 87,000$. If anyone has some advice as to any other options I would appricate some help.