Managing Student Loans: Discharging Private Loans in Bankruptcy
According to Goldman Sachs, student loans are a $1.3 trillion industry in the United States. More consumer debt is tied up in student loans than any other type of loan but mortgages.
Student loans come in two broad varieties. Most people are familiar with public or government issued and backed loans, but there is also a thriving market in private loans made by banks and other for-profit financial institutions. Private loans are not subject to the same regulations or loan discharge and management programs that are available for government-backed loans. On the other hand, private loans are generally subject to federal and state regulations that apply to other non-educational loans and are in many ways no different than car loans, mortgages and other types of personal lending.
Private loans and government-backed loans do have one important thing in common. In 2006, private loans were made non-dischargeable in bankruptcy with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). In other words, you can't automatically eliminate them in a bankruptcy case like you can other debts, like credit cards and medical bills.
That doesn't mean it's impossible to get rid of them in bankruptcy. Private loans are subject to the same discharge standard that public or government-backed loans are. More particularly, they can only be discharged if they will cause “undue hardship” to the debtor or a debtor’s dependent.
There is another way that those private loans may be discharged. That path lies in a circuitous interpretation of several federal statutes that define which private loans can be considered educational loans for purposes of bankruptcy. As we'll see, at the heart is whether you can deduct the interest on the loans from your income tax.
"Qualified Education Loans" Cover "Qualified Higher Education Expenses" for "Cost of Attendance."
In excepting “qualified education loans” from discharge, BAPCPA cross-referenced the Internal Revenue Code at 26 USC 221(d)(a), which concerns deduction for interest on education loans. Section 221(d)(a) states that interest on education loans can only be deducted from income if the loan was “incurred solely to pay qualified higher education expenses.”
Those “qualified higher education expenses” are themselves defined in the Higher Education Act of 1965, which is codified at 20 USC 108711 as “cost of attendance”. In turn, the cost of attendance is set by the college and generally includes tuition and fees, room and board, transportation and travel expenses.
As any college will attest, however, the cost of attendance will not necessarily encompass everything a student will spend in a given year. Furthermore, the amount of government-backed financial aid may be less than the cost of attendance, due to factors such as the government’s assessment of the amount a student’s family should contribute, the student’s desire for a higher standard of living, the student's family obligations, or the student’s unwillingness to seek scholarships or work opportunities. To make up the shortfall, students often resort to private loans to supplement their government-backed loans and grants.
Some private lenders limit the amount of additional lending to the difference between government loans and the cost of attendance. Other lenders, however, will agree to lend a student tens of thousands of dollars beyond the cost of attendance. Many promissory notes will contain a clause requiring the borrower to acknowledge that the proceeds will only be used for qualified educational expenses regardless of the amount of the loan.
Loans that include amounts above what is necessary to cover the cost of attendance are often called “mixed-use” loans.
Congressional Intent for Private Student Loans
When we consider the BAPCPA requirements, the Internal Revenue Code and the Higher Education Act definition, it is not at all clear that Congress anticipated these “mixed-use” loans when it decided to make private loans nondischargeable.
Furthermore, any type of lending could be considered a student loan according to these statutes, including credit card debt, home equity lending, and ordinary personal loans. The Code of Federal Regulations at 26 CFR 1.221-1, however, specifically clarifies that mixed-use loans are not eligible for an interest deduction under the Internal Revenue Code. Consequently, mixed-use loans should be dischargeable. At the least, the amount in excess of the cost of attendance is dischargeable.
To learn more about this exception to the BAPCPA private student loan discharge provision, read the FinAid.org paper, Limitations on Exception to Discharge of Private Student Loans.