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What Happens to your Student Loans when you file Bankruptcy

If you’ve read anything on the internet about student loans, you know bankruptcy probably can’t help you. Discharging student loan debt through bankruptcy is not impossible, but it is difficult, for two reasons:
1) The test is draconian with no objective standard, and
2) It is often cost prohibitive as a bankruptcy attorney needs (and deserves) to get paid.
This post is not about bankruptcy discharge, which means there is no discussion of discharge in this post. Perhaps at another time.

The question is, what happens to your student loans when you file bankruptcy? That all depends on what kind of loan and what kind of bankruptcy.

If you have Federal student loans (FSL), nothing really happens during the bankruptcy. Pursuant to the Higher Education Act, FSLs are placed into what I call, “bankruptcy forbearance”. All collection activity must stop. No monthly statements, no calls, and no payments are due. Let me clarify. Payments might be due because of your bankruptcy (Chapter 13), but no payment is required pursuant to the promissory note. This could be good – no payment due. It could also be bad. If you are in the middle of rehabilitating a default, payments will not be accepted and you’ll have to restart rehab from day one AFTER the bankruptcy is over. Timing is everything when it comes to federal loans and bankruptcy.

If a chapter 7 is filed, you’ll get a six month reprise (or longer depending on how long it takes to complete your 7). If you file a 13, you could have three to five years with no student loan payment. This could be good if you’re in a tight squeeze, but there is also a down side – no IBR payment means you are not accruing time towards forgiveness. There are bankruptcy attorneys working out kinks to allow full IBR payments during a 13, but this is a district by district issue. I can’t say where this is possible and where it is not.

The bigger problem (and I hope you don’t already know this from personal experience) are private student loans (PSL). Many PSL promissory notes contain a bankruptcy default provision. In plain English – if you file bankruptcy, your PSL defaults. For some this is not an issue. Perhaps your loan was already in default. However, many PSLs involve a co-signer. If the signer OR co-signer files bankruptcy, the PSL defaults, even if the non-filing borrower was paying the loan on time!! Yes, this happens all the time, I see it every week. Worse, the non-filing borrower gets a credit ding because the PSL defaulted. OUCH! Talk about strained family relations (most PSL co-signers are family members).

The small good news is that a Chapter 13 comes with an automatic co-debtor stay. In other words, the lender cannot go after the non-filing borrower during the 13. The lender can petition the court to allow this, but I am not aware of any lenders doing so, at least not on a routine basis. A Chapter 7 filing does not have this protection, but then again a 7 is usually completed in six months or so. A lender doesn’t mind waiting until the completion of a 7 to go after all signers.

But isn’t it illegal to default a loan just because you file bankruptcy? Excellent question! While there is case law that disallows this for other kinds of loans, like car loans and such, there is NO case law giving a decision either way when it comes to PSL default. If you’re in this situation, ask your bankruptcy attorney to look into this. Ask them about the “ipso facto clause” that causes default upon the filing of bankruptcy. The attorney can look into this for you.

In the end, if you have to file, you have to file. Don’t NOT file just because of a student loan issue. Only you and your bankruptcy attorney can determine the best course of action. Now that you know what really does and does not happen with your student loans, you can make a better educated decision.

Comments

  1. MJ

    Hi Joshua,

    I am looking into filing because of my PSL. Which you, and others, have noted is not a good reason to file. I have a couple of questions, I ask here because American Education Services doesn’t give me a direct answer.:

    – If I default on PSL in which I have a co-signer and that co-signer also refuses to pay, what happens? I imagine my credit will suffer, as well as the co-signer, correct? If so, for how long?
    -Can the company get a court order to garnish wages? would they do so to both me and my co-signer? Is there a limit as to how much they can take?

    Thanks for your time,
    MJ

    • Joshua Cohen

      Answering generally, yes, you and your cosigner can be sued. As to wage garnishment and how much, I cannot answer because it varies state-to-state. Contact a local consumer attorney for specific answers.

  2. John B

    I filed for bankruptcy in November. My student loans were current, and since they should not be discharged, I did not expect them to be affected. However, they were put under “bankruptcy hold” and Navient will not give me a statement to help me show the Financial Aid department that I am not in default, thus affecting my loans for second semester. Is there any way that I can show that I am not in default so that I can restore my eligibility for spring semester loans?

  3. Sydney M

    How does Statute of Limitations affect Bankruptcy? Is Statute of Limitations paused?

    • Joshua Cohen

      You mean how does bankruptcy affect SOL. It tolls it – yes, pauses during a bankruptcy.