*A note from the author: It is my sincere hope that anyone considering obtaining a student loan will read this prior to committing to thousands of dollars and many years of debt. While laws and regulations concerning student loans change often and can vary based on the year the loan was obtained, the information outlined here is intended to be representative of the student loan system in general.
"Student Loans - Open Secrets of the System and What You Need To Know"
Man plans, God laughs - or so the saying goes - and students plan as well. Every year thousands of them plan for a future including an undergraduate education or graduate school. Many take out student loans to help meet ever-increasing tuition costs, fees and living expenses. Few, however, realize that once they've signed on the dotted line they just may have acquired a debt FOR LIFE.
For LIFE, you say? Well, at least for a full working life through retirement age, that is. While a majority will never experience anything more than the standard ten-year repayment period, and while everyone hopes for the best, what happens if something goes wrong? What happens when plans go awry and a person can't meet his or her loan obligations? Several options exist along the way, to be sure. But among the most expensive are debt consolidation programs which can extend the repayment period from 10 to as long as 30 years.
Considering the average undergraduate finishes college in the early 20's, and a graduate student in the mid- to late- 20's or early 30's, some students could conceivably be paying off their debts until they are nearing retirement age. And although most people don't know it, unlike other debts, student loans are generally NOT DISCHARGEABLE in bankruptcy.
So what happens? In order to understand the full process, it is necessary to understand the genesis of the student loan system, the process by which most students obtain their loans, the options available for repayment, and the issue of non-dischargeability of loans through the bankruptcy courts, except by special petition.
The Higher Education Act of 1965
The student loan program which exists today had its genesis in the Higher Education Act of 1965. In the legislative history for the act as contained in Volume 2 of the U.S. Code Congressional and Administrative News, several reasons were cited for the "pressing requirements for fresh, vigorous congressional action in the field of student financial assistance" (p. 4053). These included "the continuing upward spiral of the cost of education beyond high school, the rapidly mounting size of high school graduating classes - beginning with the record-setting number of graduates in the June 1965 class - and the aggravated plight of students who do not have the means to acquire education." (p. 4053).
By that time, the postwar middle class had grown immensely. As the "baby boom" children reached college age, it was noted that "financial pressure now bears heavily not only on the low and lower-middle income families but also on middle and upper-middle income families who only a few years ago would have been adequately capable of paying for their children's education." (p. 4059). In order to alleviate this financial burden, it was proposed that the "heavy concentration of expenses should be spread out over more than four years of college through the 'loan of convenience' described in part B of title IV" (p. 4060). Hence the birth of the Guaranteed Reduced Interest Loans to Students program, or the Guaranteed Student Loan program as it is commonly known today. Back then it was described as a part of the "national commitment to offer every child the fullest possible educational opportunity" (p. 4060), and a "FINAL LINE OF FINANCIAL DEFENSE for families and students from all levels of income." (p. 4061).
In the nearly 40 years since the program's inception, not much has changed as far as the original justifications for [the program's] existence. College costs still continue to rise, and lower- and middle-income families still face difficulties in paying for their children's educations. As the program has grown, and the number of students obtaining student loans has increased, however, the system has begun to show signs of strain. And often those who pay the highest price - both literally and figuratively - are the students who can least afford it. That is not to say that student loans are inherently bad, for in this author's opinion they are not. Many lives have been changed for the better by their availability. Perhaps one of the greatest problems on the borrowing side is that for many the loans have gone from being a "final line of financial defense" to true "loans of convenience" in every sense of the word, or easy money.
Choosing a School and Obtaining a Loan
While each person's motivation for attending college or graduate school is highly personal, the process for getting there is fairly standard. One applies, gets accepted or rejected, picks a program, and (assuming one doesn't have a full scholarship or an otherwise free ride) figures out how to pay for it. In most cases, the school determines a student's need and aid eligibility, then tells the person what they will offer and how much the student and/or student's family must contribute.
In judging the affordability of a program and choosing the option to accept student loans, a few "reasoned assumptions" may come into play. They are that 1) The loans will be repayed from future earnings, 2) The education, particularly in the case of graduate school, will be applied over the course of a professional lifetime, and 3) Estimates of potential earnings can roughly be approximated from public information (published newspaper and magazine articles and surveys, school brochures, career guides, etc.) and private sources (friends, colleagues, others who have attended the same or similar programs, etc.).
Of course there is some risk in making this evaluation. For many four-year colleges and graduate schools today, the amount of loan aid to students is close or equal to, if not more than, the amount people pay as down payments on their homes. In this regard, even the courts have expressed some opinion in the matter. In a case dealing with student loans, Matter of Rivers, 213 BR 616 (page 621, Footnote 4), it is stated that:
" . . . While a home buyer thinks in terms of a multiple of present gross income to predict the amount of an affordable mortgage, a student loan debtor must look beyond present income to some point in the future, to predict the amount of student debt which can be repaid without hardship. This is because there must be some interval of time before a debtor might begin to fully enjoy the financial benefits of the investment in education. While the income prospects of debtors will vary, the method of analysis of their respective abilities to service debt might be the same. They should each be able to afford debt payments which bear some relation to the amount of income they can expect to receive. Testing hypothetical scenarios, and noting the use of a rule of thumb in the mortgage lending industry, it may be reasonable to conclude that a student loan debtor should be able to repay without 'substantial hardship' a debt in the amount of gross income he or she expects to receive in the tenth year of employment. When considering the various educational possibilities and costs associated with them, this rule of thumb may offer an additional avenue of analysis to aid in determining whether the educational debt is out of proportion to the earning ability of the student."
For many, the risk of assuming the financial burden is obviously more than offset by the perceived future value of what can be expected upon the completion of an undergraduate or graduate degree. So, with acceptance letter in hand, the final process for obtaining the loan(s) begins. Although exact procedures may vary from state to state and agency to agency, most student loan applications are simple one-page forms. Little more than one's name, the name of the institution one will be attending, the amount of money requested and a signature are required, and the paperwork can be completed quickly. Indeed, one internet-based student loan provider has advertised that on-line applicants can have their applications processed in one minute. After that - presto! A check for half the total amount (in the case of a program with two terms per academic year) appears at the school each semester.
Fast forward ahead to the end of school and the start of loan payments. The regimen is standard and prescribed by law. Repayments usually begin six months after a student's graduation date. Shortly before the first payment is due, the loan holder is notified of the total amount owing, the amount of the monthly payments and the applicable interest rate. Unless otherwise stated, repayment rates are calculated based on a ten-year period. For some loans such as the Stafford Loans, the balance owing at graduation is the same as the original amount borrowed. For others, such as the Supplemental Loans, interest is capitalized during the student's years in school, then added to the principal balance owing at graduation.
The concept of interest capitalization is one with which every student loan holder should be very familiar. Capitalized interest is interest due on a loan which, after having accrued for a certain period, becomes principal and is added to the principal balance owing. In the case of Supplemental Loans, for example, no payments are due as long as the student is still in school. During that period, however, interest begins to accrue. One is given the option of paying the interest immediately. If not paid, however, it is capitalized and added to the principal balance when the student begins making post-graduation payments. In effect, the capitalization process becomes one of paying not only interest on original principal but also paying interest on interest.
A person making regular payments for the normal life of the loan is unlikely to have additional capitalized interest included in scheduled repayments. But again, what if something happens? There ARE many options available. Although most have the advantage of lowering or temporarily suspending payments, almost all bear some type of penalty for the loan holder. Three broad categories of those options are described below.
The first option to consider if it is necessary to halt payments is forebearance. This is a suspending of loan payments due primarily to unemployment or economic hardship. Although there are other types of forebearances, such as for full-time students, those wil be discussed later. The maximum period allowed under law for those programs, three years, is set in Title 20 of the U.S. Code Section 1087dd.
Economic hardship as the term relates to student loans is defined in Section 1085 (o) of Title 20 of the U.S. Code. The three definitions are: 1) Full-time earnings which do not exceed the greater of the minimum wage rate or an amount equal to 100 percent of the poverty line for a family of two, 2) A Federal educational burden which equals or exceeds 20 percent of a borrower's adjusted gross income, with additional criteria based on comparisons to minimum wage and the poverty line, and 3) other criteria determined by the Secretary of Education in which the borrower's income and debt-to-income are considered as primary factors.
At first glance, the advantages of a forebearance are many and the disadvantages are few. As with the initial loan, the application process is easy and usually involves no more than the completion of a single short form. Loan payments cease immediately upon approval, and for many, a short one to three year break from payments may be all that is necessary to regain financial footing. However, all interest accrued during the period is capitalized and added to the principal balance at the time when new payments begin. Depending on the length of the forebearance and the total amount owing, this can add up to hundreds or even thousands of dollars on top of the already-existing debt.
The second option available is student loan consolidation or refinancing. Over the years Sallie Mae (the Student Loan Marketing Association) has referred to two programs of this nature as the Select Step and Smart Loan Accounts. Programs of this kind allow a person to lower payments in the short term in exchange for extending the overall loan repayment period from 10 years to as long as 30 years. The borrower usually must commit up front to a post-consolidation amount due which can be more than double the amount of the loans originally obtained. Interest-only payments can be made for either the first two or four years following the consolidation, and for those who would prefer to make a small payment rather than no payment at all, this may be preferable.
Here again, however, the comparison of a student loan to a mortgage might be used. The original promissory notes signed by a student indicate a repayment period of not more than ten years. If a person voluntarily commits to extending the repayment period beyond ten years, the person is in effect assuming a mortgage-like debt without the same benefits as a mortgage. By this the author means that from the moment someone begins making mortgage payments they begin building tangible equity in the value of their home. This is not necessarily true in the case of the purchase of an education. In fact, if a student is forced to consider consolidation based on an inability to reach a projected level of income or apply an academic credential in an intended field, it is almost the exact opposite.
Say a person obtains a student loan initially as the basis for what might be termed "professional" or "employment" equity in their future (which includes an assumption of an income necessary to make payments on the loans). Any extension of the 10-year period might be looked at more as a decrease in that "professional equity" than a reflection of the increasing value of an education. Also, at the end of a 15- or 30- year mortgage, a home owner is free to sell the home and pocket the profits, which is not a concept one can apply to student loan debt of the same nature.
Other Forebearance and Debt Rescheduling Options
Numerous other programs exist, including income-sensitive repayment accounts. These accounts, if approved, can be used to adjust payments based on income-dependent criteria. These have the effect of lowering monthly payments without placing the loans in forebearance or undertaking a consolidation. As with other payments of this nature, however, monthly payments must be at least equal to the amount of interest due on the account for any given month. If such relief is sought early on in the repayment period, it may be of little value in substantially lowering payments. This is because interest is a much greater component of monthly debt than principal in the initial stages of paying back the loan.
Finally, public service forebearances exist for those who serve in professions such as teacher in a designated teacher shortage area, or member of the armed forces, or for those in the Peace Corps. Again, while the forebearance period may provide a cushion of time in which to rebuild financial footing, it does nothing to actually decrease the student's debt. Interest still accrues on the account and is capitalized at the end of the forebearance period.
While many students find solutions in the programs listed so far, some do not. Without resolution of the debt or the rescheduling of payments, it is likely that the loans will slip into default.
One might assume that by defaulting on a student loan the balance would be frozen, but that is not correct. In addition to continuing to accrue interest, collection fees are tacked on to the total amount owing and a distinctly unsavory process begins. Loan accounts are handed over to collection agencies who begin a series of phone calls demanding repayment. Credit agencies are notified of the default and credit ratings, if not already damaged, are totally destroyed. Regular correspondence is issued notifying the debtor of what is called an offset, meaning that wages can and will be garnished, tax refunds withheld, and in at least the case of California, lottery winnings (should the debtor be so lucky) confiscated (in the amount owing on the loan). Even after all of this, the debtor is still not free of the student loans.
The primary option for post-default debtors is something called the William D. Ford program. Although this program can set the loan holder on the course to rehabilitation of the loan (defined in Title 20 of the U.S. Code as the successful completion of 12 consecutive monthly payments), it is a Federal Direct Consolidation Loan. Upon a debtor's acceptance of the terms of the program, all interest accrued during default is capitalized, and a new repayment schedule formulated. Payment levels may be set according to standard or income-sensitive repayment plans, with all the negative ramifications for the debt-holder already discussed above. A person with insufficient income to make large monthly payments could be forced to accept a repayment schedule lasting another twenty or thirty years, in effect doubling or even tripling the amount originally borrowed.
At this point some might begin to question whether or not the tremendous amount of interest accrual and escalating payments on these "Guaranteed Reduced Interest Loans to Students" could be considered usury. By a legal definition included in Section 1078 of Title 20 of the U.S. Code they could not. Congress has specifically exempted student loan guarantee agencies from usury laws by saying, "No provision of any law of the United States . . . or of any State (other than a statute applicable principally to such State's student loan insurance program) which limits the rate or amount of interest payable on loans shall apply to a loan (1) which bears interest (exclusive of any premium for insurance) on the unpaid principal balance at a rate not in excess of the rate specified in this part; and (2) which is insured (i) by the United States under this part, or (ii) by a guaranty agency under a program covered by an agreement made pursuant to subsection (b) of this section." What this appears to say is that regardless of how much interest is capitalized, since the actual interest rate used to calculate any payment is never above the legally allowed rate, the system is not usurious.
If the loans are not rehabilitated in the post-default period, one of the few options left for the debtor is to file for bankruptcy. Although by definition student loans are not dischargeable in bankruptcy, there is one exception to this rule.
Student Loans and Bankruptcy
Under the U.S. Bankruptcy Code, section 523 (a)(8), student loans made, insured or guaranteed by a governmental unit are not dischargeable in bankruptcy. However, the one exception to the general rule contained in 523(a)(8) is in the case of "undue hardship" on the holder of the student loan or that person's dependents. (*For a reader interested in the subject of student loans and bankruptcy, the article "Forging Middle Ground: Revision of Student Loan Debts in Bankruptcy as an Impetus to Amend 11 U.S.C. Section 523 (a)(8) is recommended. It can be found in 75 Iowa Law Review 733 (1990)).
Laws in this area have changed continually in the last decade with the trend moving toward increasingly restricting the ability of debtors to discharge any student loan debt in bankruptcy court. Section 523 (a)(8) was first inserted into the Bankruptcy Code as a part of the Education Amendments of 1976. According to the Iowa Law Review article cited above, p. 734, the section was "largely a result of concerns that developed in the early 1970s about abuse of the student loan programs. The specific concern that spawned this Code section was the need to close what critics characterized as a 'loophole' in the student loan program. This 'loophole' allegedly allowed graduating students to discharge their loan obligations through bankruptcy on the eve of lucrative careers without accounting for their ability to repay . . . While this 'loophole' concern appears to have been more myth and media hype than reality, it stirred public emotions and forced Congress to act."
Up until a couple of years ago, there was also a timing element factored into Section 523 (a)(8). A debtor had to wait a certain number of years from the date of the first loan payment following graduation before a filing could be made. At first it was five years, then in 1990 it was raised to seven years. This is also where another downside of both forebearances and consolidations came in. If a loan had been in forebearance, the length of that forebearance would have been added to either the five or seven years before the debtor could consider filing under Section 523 (a)(8). If loans had been consolidated, the clock would have started anew. Say, for example, that a debtor accepted a consolidation program five years following graduation when the time period in the Bankruptcy Code was seven years. If things didn't go well for the debtor, the person could not have filed for bankruptcy two years later. Ther person would have had to have waited another seven years from the date of consolidation.
This point is now moot, however. As explained on page 523-121 of the part of Collier on Bankruptcy dealing with loan discharge, "In 1998 . . . Congress deleted Section 523 (a)(8)(A) from the Code, leaving 'undue hardship' as the sole basis for discharging an educational loan or benefit. The elimination of the rule applies to all cases commenced after October 7, 1998." So what does the court define as "undue hardship?" It is difficult to say since there is no official definition of the term. Discretion on the matter is left up to the bankruptcy court judge hearing a particular case. The burden of proof of undue hardship is on the debtor, but there are several precedents in case law from which "tests" have been developed as generally (though not universally) accepted standards.
The first and most important test is the "Johnson" test developed from a case heard in 1979. The following section (from Norton Bankruptcy Law and Practice 2nd, 47:52, pages 47 - 142/145), though somewhat detailed, is a good description of the way which courts judge debt dischargeability based on existing precedent.
"Under the first test in the Johnson analysis, known as the 'mechanical' test, the court must determine whether the debtor's financial resources for the forseeable future will be insufficient to enable the debtor (and any dependents of the debtor) to live at or above a subsistence level. Under this test, numerous factors are examined including, but not limited to, the number of debtor's dependents, and their ages and needs; health of the debtor and his or her dependents; access to transportation; level of education attained by the debtor; day-to-day living expenses; marketability of the debtor's job skills; current income; and other sources of wealth. If the debtor fails to meet the burden of proof under the mechanical test, the court may deny discharge of the debt. If the debtor meets the burden, the court does not decide whether the debt is dischargeable but proceeds to the second test under Johnson."
The second test, 'good faith,' is an implicit requirement to dischargeability of a student loan. Courts have held that although the student loan debt many impose an undue hardship on the debtor and his or her dependents, the debt will not be discharged unless the debtor demonstrates a good faith attempt to make payment on the loan. Further, this 'good faith' requires an examination of such factors as the debtor's efforts to obtain and retain employment; the debtor's present employment status; the debtor's employment record; whether the debtor's education and skills are being used to the best advantage; and whether the debtor and his or her dependents are living within their means. If the debtor fails to meet the good faith test, the court excepts the student loan debt from discharge."
If the debtor meets the 'good faith' test, the court must engage in one final analysis, known as the 'policy' test. Under the policy test the court must determine whether a discharge of the debt in question constitutes the type of abuse which Congress sought to prevent by Bankruptcy Code Section 523 (a)(8). Only if the debtor succeeds under all three tests is the debt discharged."
"The other approaches taken to determine whether an undue hardship exists may be summarized succinctly. One approach follows the analysis described above but 'presumes' the loans to be excepted from discharge and requires 'truly severe and even uniquely difficult circumstances' to rebut the presumption. A third approach determines hardship in terms of Federal Poverty Income Guidelines established by the Department of Health and Human Services. Finally, some courts look to the 'totality of circumstances' to 'manage the equities of the case'."
"Recently the Second, Third and Seventh Circuit Courts of Appeal have rejected the Johnson three-part test in favor of a three-part test which deletes the 'policy test' employed in Johnson. Under this new approach, set out by the Second Circuit's opinion in Brunner v. New York State Higher Educational Services Corp., a finding of 'undue hardship' requires . . . (1) that the debtor cannot maintain, based on current income and expenses, a 'minimal' standard of living for [himself/herself] and [his/her] dependents if forced to repay the loans; (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans; and (3) that the debtor has made good faith eforts to repay the loans."
The Third and Seventh Circuits adopted the Second Circuit's approach, concluding that the Johnson 'policy test' was inappropriate because 'the decision of whether or not to borrow for a college education lies with the individual . . . If the leveraged investment of an education does not generate the return the borrower anticipated, the student, not the taxpayer, must accept the consequences of the decision to borrow'."
As said earlier, this undue hardship test is now the sole basis for discharging student loan debt in bankruptcy court. For those who might think about waiting until the statute of limitations on collecting the debt expires, forget it. Congress repealed those in regards to student loan debt, so there is no time limit on collecting on loan obligations when they are due.
Although the problems surrounding student loan debt have largely remained out of the public dialogue, there are signs, like the New York Times article cited earlier, that this might be changing. Questions need to be asked of all parties to the transactions. Borrowers need to ask themselves if they can do without the loans or at least accept the lowest amount possible to get by. Schools need to ask themselves if they are doing everything possible to keep their promises to their students or aid in placing them in work relevant to the level and type of education received. Loan agencies must ask themselves if they're doing everything in their power to find reasonable and timely solutions for students who are legitimately unable to make payments on their loans. And Congress and the courts need to ask themselves if it is truly fair to hold student loan debt to so much of a higher threshold than all other types of debt. It is only then that an open and meaningful dialogue can begin on an issue so important to the future of so many in this country.