Student Loans: Time to Reform the Law That Treats Debtors Like Crooks

Last Updated Dec 13, 2010 4:12 PM EST

Conservative Congressmen hate students who take loans. They lump them with tax cheats, criminals who owe reparations, and deadbeat dads.

What do these people have in common? None of them is allowed to discharge the debt in bankruptcy. People who take loans for higher education and, later, fall on hard times, are considered unworthy of a fresh start in their financial life.

A handful of legislators want to change the law, to restore former students to their place in respectable society. But powerful forces stand against them -- not only the lenders but also their Congressional pals. They believe that anyone with a college loan should be treated more harshly than consumers who run up other types of debt.

You might make the argument that federal student and parent loans should not be discharged in bankruptcy. They're insured by the taxpayers, who deserve their money back.

But what about the private loans made by banks and other education lenders? Bankers are capitalists. They assess the borrower's risk and apply variable interest rates, currently up to about 12 percent and sometimes higher. Why should the U.S. government act as their debt collectors? I thought that bankers wanted the feds out of their affairs.

Back in the day, private student loans could be discharged in bankruptcy, just like any other unsecured consumer debt. Many lenders got around that law by issuing loans through nonprofits, which usually kept them out of bankruptcy court.

The Bankruptcy Reform Act of 2005 straight-out exempted private loans from bankruptcy and from the normal business risk of loan default. Lenders could levy whatever terms they wanted on student and parent borrowers, and threaten them with permanent servitude if they couldn't pay.

That's where the bill now in Congress comes in. It returns education lenders to the private sector where they belong. The Private Student Loan Bankruptcy Fairness Act passed a House subcommittee, chaired by Tennessee Democrat Steve Cohen, on a party-line vote (with the Republicans against). Borrowers would still have to repay their federal loans but private loans could be discharged.

Naturally, the lenders are fighting to keep their privileged and profitable position. They argue that all education loans -- public and private -- should be treated the same.

But private loans are an entirely different product. Unlike federal loans, the private loans have no caps on interest rates and fees, and no forbearance requirements. Rates are variable, not fixed. Co-signers (mainly parents) have to repay the loans even for students who die or become disabled -- conditions that would cancel a federal loan. The private lenders want government protection without matching the government's pro-consumer terms.

They also argue (in my hyperbolic words, not theirs) that students of any age are inherently less moral than the population in general. When they leave school, they "will be encouraged to declare bankruptcy" and dump their student debt before they start acquiring assets and income, the Consumer Bankers Association says. That's like saying they have incipient fraud in their souls.

There are always people who will indeed try to beat the system, just as there are always banks that will try to take advantage of their customers. But there's no evidence that borrowers with some higher education take bankruptcy more lightly than others, says attorney Deanne Loonin of the National Consumer Law Center.

The only systematic study of this question dates back to 1977. It found that only a small fraction of 1 percent of student loans had been discharged -- a number that "compares favorably with the consumer finance industry," the study said. An even tinier percentage of borrowers would have been deliberately ducking their obligations. Almost all bankrupts are truly broke.

What's more, bankruptcy isn't cost free. It stays on your record for up to 10 years, preventing you from getting credit at a decent interest rate, and making it hard to buy a house or car, rent an apartment, or even get a job. Lauren Asher, of the Project on Student Debt, quotes a bankruptcy lawyer as saying "people would rather have a root canal without anesthesia than be sitting down and talking to me."

The student lender Sallie Mae says it's willing to compromise. It would be okay to discharge private loans in bankruptcy, provided that the rule applied only to future loans, not current ones. Also, a borrower would have to have paid, or made a good faith effort to pay, during the previous five to seven years.

But the cascade of bankruptcy can come fast, Asher says. It makes no sense to hang people with extra debt just because their wreck came after four years instead of five.

Sarah Ducicich, Sallie's senior vice president for public policy, says the company works with strapped borrowers -- granting them short periods of nonpayment and temporarily cutting their interest rate. That helps get them through a bad patch but runs up future costs. The truly broke will default on their payments. That shows up on their record for seven years, but they face a lot of dunning along the way.

In theory, there's one way to get student loans discharged in bankruptcy today. You can show "undue hardship," meaning that -- now and in the future -- it's clearly impossible to pay. But the rule is so arbitrary it's almost cruel. To have any chance of success, you need a lawyer to plead your case.

Even then, the outcome depends on the biases of a particular judge. In one case, a judge excused a low-earning couple -- a teacher's aide and a teacher who worked with emotionally disturbed children -- who had been unable to find an affordable loan-repayment plan. In two other cases, judges refused relief to an orchestra cellist who taught music part time and to a pastor in a new church. Those borrowers were callously told that they could pay off their loans by finding a different, higher-paying line of work.

The undue-hardship rule needs reforming, too.

More on MoneyWatch:
Private Student Loans: 6 Ways to Make Them Better
Student Loans: The Best Places to Borrow
Are You Paying Too Much for Financial Planning and Advice?
  • Jane Quinn

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