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How Bankruptcy Affects Your Student Loans

There’s a common misconception that student loans are impossible to discharge. Granted, the test for discharging student loans is difficult, perhaps unreasonably so. Filing for student loan discharge is also cost-prohibitive—you’ll absolutely need an attorney to help you do it, but paying them is difficult for people who are unable to make their student loan payments.

However, there are definite advantages to doing so if you can afford it. Below, we examine South Carolina’s bankruptcy laws, student loan rules, and the ways that different types of bankruptcy can protect you from collectors and give you financial breathing room. In addition, we take a look at 2 of the tests courts will use to determine if you qualify.  

First, some basic bankruptcy terms:

  • Discharged Debt – This is debt that the court has released you from repaying. It’s totally forgiven and you have no obligation to it. Collectors are forbidden from attempting to solicit you to repay it.
  • Secured Debt – Any debts where property is attached as “security.” Mortgages and car loans are the most common forms of secured debt. If the bank can take it away from you legally, it’s secured debt.
  • Unsecured Debt – Debt where the loan has no property attached to it. Credit card debt, medical debt, and student loans are all considered “unsecured.”
  • Liquidation – The process of turning assets into currency. This could include anything from selling your belongings for cash to redeeming government bonds or selling stocks.

Federal Student Loans & Bankruptcy

For people with federal student loan debt, bankruptcy stops all collection activity during the bankruptcy process. You will receive no mailed or electronic statements, you will receive no collection calls, and you will have no payments due. Now, your relief period can vary from 3-5 months to 3-5 years depending on the type of bankruptcy you file for.

Chapter 7 Bankruptcy & Federal Student Loans

Chapter 7 bankruptcy is known as a “liquidation” bankruptcy. The debtor discloses and liquidates all their non-exempt assets (extra vehicles, collector’s items, valuable electronics, etc.) to pay off creditors. Once their non-exempt assets are sold and any secured debt is settled (or repossessed), the rest of their unsecured debt is discharged.

Note: some debt cannot be discharged in bankruptcy. For more information, check out our blog on what bankruptcy can and cannot do.

Because a Chapter 7 takes about 3-4 months to complete, you’ll have relief from federal student loan repayment for a short time. However, student loans do not automatically discharge like other unsecured debts do. You’ll need to file a Complaint to Determine Dischargeability during the bankruptcy hearing. You will not have an opportunity to do this afterward, so prepare to do this as soon as you file.

Surprisingly, very few people with student debt ever file the complaint—even though 40% of petitioners have all or some of their student debt discharged! If you have very little to contribute to your debts overall, the court may choose to discharge your loans completely. There’s no risk in filing the complaint, but the potential rewards are enormous.

Chapter 13 Bankruptcy & Federal Student Loans

Known as the “wage earner’s bankruptcy,” Chapter 13 allows debtors to create a repayment plan, consolidate all of their debts into a single debt, and spend 3-5 years making a single monthly payment with the help of a trustee. How much a debtor pays back every month is calculated according to their disposable income—meaning it doesn’t include the money they need to survive (rent, groceries, etc.).

Chapter 13 arrangements give student debtors 3-5 years of relief from collectors, but there are a few pros and cons to this arrangement. For one thing, during your entire bankruptcy, voluntary payments will not be accepted by your lender. If you were planning on having your student debts forgiven after 20 years of income-based repayment (IBR), any IBR plan will be paused and no time will accrue toward debt forgiveness. In addition, loans will continue to accrue interest.

The good news is that you’ll be able to get ahead of the rest of your debts, putting you in a stronger position overall at the end of your repayment plan. The other good news is that your student loans are classified as non-priority unsecured debt, so you’re not required to pay off the full amount in 3-5 years.

Finally, if you were hoping to shake off your loans, Chapter 13 does not allow for student loan discharge. You’ll be responsible for the remaining amount after the repayment plan is finished. The good news is that your other unsecured debts will be discharged, and you won’t be forced to sell any of your belongings like in a Chapter 7.

Private Student Loans & Bankruptcy

If you’re one of the millions of Americans with private student loans, there are some things you need to know. Declaring bankruptcy affects private student loans differently than federal loans. For one thing, declaring bankruptcy automatically marks all signers as defaulting on the loan, regardless of whether one signer was faithfully making payments.

Loan default destroys both signers’ credit scores and limits their ability to borrow in the future for years. For many families, this is terrible news: most private student loans are co-signed by relatives.

If you’re wondering how that’s legal, you’re not alone. It is actually illegal for lenders to automatically default a loan in response to bankruptcy for things like car loans. However, that’s only true because legislative bodies signed such protections into law. No statutes protect student loan debtors from such aggressive consequences.

Thankfully, there’s some silver lining for Chapter 13 filers: this bankruptcy format comes with an automatic stay for co-debtors—meaning the lender cannot go after the non-filing borrower.

Court Tests for Student Loan Discharge

Bankruptcy courts will use 2 three-point tests to determine if you are eligible for student loan discharge: the Brunner test and the Totality of Circumstances test.

To pass the Brunner test, you need to prove all of the following are true:

  • It’s impossible for you to maintain a minimal standard of living
  • Your financial situation is not likely to change anytime soon
  • You’ve made a good faith effort to pay back loans

For the Totality of Circumstances test, the court will consider the following:

  • Past, present, and future financial resources
  • Reasonably necessary living expenses
  • Relevant facts and circumstances to your bankruptcy

Passing either of these tests is unlikely without the counsel and experienced hand of a bankruptcy attorney. At Lam Law Firm, Attorney Lam is one the leading bankruptcy lawyers in Myrtle Beach. She has the vast experience and precise strategies you need to get a fresh start.

Call (843) 695-7700 today to learn how Lam Law Firm can help you find debt freedom.