Report: Let private student loans be discharged in bankruptcy
Borrowers overwhelmed by private student loan debt often discover an ugly truth too late — these loans can't be discharged in bankruptcy like other types of consumer loans.

A new report on private student loans by the Consumer Financial Protection Bureau and the U.S. Department of Education suggests it may be time to change that. The agencies say these loans offer so little flexibility to struggling borrowers that Congress might consider revising the bankruptcy law given today's tough economy.

Bankruptcy, of course, should never be entered into lightly because the repercussions are long-lasting. Those who file for bankruptcy end up paying higher interest rates for credit cards or for a mortgage, if they can get one. A bankruptcy can also knock you out of the running for a job. And the black mark stays on credit reports for as long as 10 years.

But when twentysomethings have $100,000 or more in private loans and little prospect of finding work, they need the kind of relief that will give them a fresh start. And that's bankruptcy.

"The issue has gained a lot of attention and support as people become more aware of how different and more dangerous private loans are compared to federal loans, and how little recourse private loan borrowers have if they hit hard times," said Lauren Asher, president of the California-based Project on Student Debt.

Asher adds that private loans are similar to credit cards — but plastic can be discharged in bankruptcy.

"They don't call credit cards financial aid when they're used to pay tuition or books," she said. "Neither are private loans. ... They are a private and commercial product designed to make money. They are like credit cards and charge the highest rates [to those] who can least afford them."

Before the mid-1970s, federal and private education loans could be wiped out in bankruptcy. Congress then started to restrict federal loans from being discharged. In the mid-1980s, private loans guaranteed by a nonprofit agency became exempt from bankruptcy. Many lenders took this route to make their loans bankruptcy-proof.

A 2005 bankruptcy law further shielded financial institutions — giving their loans the same treatment as federal loans. Now, no education loan can be discharged without an "undue hardship," a hurdle rarely overcome.

It's so rare, in fact, that a bankruptcy judge in Baltimore made national headlines recently when he discharged about $340,000 in student loans, says Robert Grossbart, a Baltimore bankruptcy attorney. The borrower suffered from a disorder that prevented her from working.

The CFPB and the Education Department noted that the congressional record has little to say about why private loans in 2005 needed special treatment over other consumer loans. The two agencies said they found little evidence that the change has resulted in lower loan prices to consumers or greater access to credit.

Lenders aren't happy about the prospect of bankruptcy changes.

"We made a contract with students to repay their loans, and that's how the banking system operates," said Richard Hunt, president of the Washington-based Consumer Bankers Association. Hunt predicts a rush of bankruptcy filings if private student loans are allowed to be discharged in bankruptcy.

And if banks continue to make loans after the law is changed, Hunt said, "there is no question you will get an increase in interest rates."

Student loan giant Sallie Mae has been open to compromise, supporting a bankruptcy option for loans after borrowers made good-faith payments for five to seven years.

Otherwise, new grads with high debt and few assets could immediately file for bankruptcy, Sallie Mae's president, Jack Remondi, warned during a congressional hearing last week That was why student loans became exempt in the first place, he said.

Sallie Mae contends that if private loans become dischargeable in bankruptcy, so should federal loans.

But federal loans aren't the big problem.

When borrowers get into trouble with federal loans, they can get a deferral, forbearance or choice of flexible repayment methods. For instance, borrowers with high debt and low incomes can qualify for an income-based repayment plan that reduces monthly payments — to zero in some cases. The government also offers loan forgiveness for public service workers.