Guest post by Aaron N. Taylor.

America’s love-hate relationship with debt has found a new dread: student loans. With the housing crash still fresh on everyone’s mind, fear of a new bubble filled with worthless student loan debt has come to fore. This heightened (if not hyper) state of concern is understandable.

Topping $1 trillion, student loan debt now exceeds credit card debt (though that may not be a bad thing). Last year alone, students borrowed $100 billion for school. Additionally, a recent study found that 27% of federal student loan borrowers in repayment have past due balances, with 10% being delinquent. Many more are making reduced payments through income-based plans.

This data is concerning and portends an increase of debtors seeking to discharge their student loan debt in bankruptcy. Unfortunately, our means of assessing the propriety of such discharges are woefully subjective and inconsistent. The result is a highly inefficient system that falls far short of notions of justice and fairness. In this article, I propose an objective framework for assessing the propriety of federal student loan bankruptcy discharges.

Before I get into the specifics of the proposal, let me correct the ubiquitous misconception that student loans are virtually impossible to discharge. Student loans are dischargeable in bankruptcy—both in theory and in fact. Surprisingly, not much empirical research has been done on the topic. But in a 2003 study, 57% of debtors seeking to discharge student loans were successful. A follow-up study of bankruptcy cases filed between 2002 and 2006 found similar trends. At the very least, this limited data debunks the “impossibility” meme. Discharge is possible. It happens. It’s just difficult to predict when and to what extent.

Why We Need To Undo Undue Hardship

A debtor seeking to discharge student loans in bankruptcy must prove that paying the debt would cause an “undue hardship” upon him and his dependents. Undue hardship, however, is an undefined concept. Should the words be construed literally or conceptually? Should they be defined separately or together? One bankruptcy court stated that undue hardship was a “phrase with a particular legal meaning and function”. Conversely, another court (in the same circuit, no less) reasoned that “the plain, ordinary meaning” of the words was sufficient in taking a “common sense” approach to defining the concept.

Courts also struggle with determining the extent or degree of hardship that should be embedded in their definitions. One court stated that in order for a hardship to be “undue,” there must be a “certainty of hopelessness” about a debtor’s ability to make the payments. In contrast, another court stated that such a standard is antithetical to the fresh start ideal of bankruptcy, and thus required debtors to show only a “reasonable” chance that paying their loans would force them to live below poverty.

Adding to the muddle are at least four undue hardship “tests” that courts use. The most popular test, Brunner, requires a debtor to show that his loan payments would require him to sacrifice a “minimal standard of living” into the future and that he has made good faith attempts to repay the debt. But what is a minimal standard of living? How is future inability to pay predicted? And what constitutes good faith efforts to repay?

The Johnson test requires a debtor to first demonstrate a current and future inability to make loan payments. She must also show that her living expenses are reasonable. She must then show either that she has made good faith efforts to repay or that she has received little financial benefit from her education and discharging student loans is not her overwhelming reason for filing bankruptcy. Got that? Like Brunner, critical elements of the Johnson test are based on ambiguous and subjective concepts.

Some courts take a “totality of the circumstances” approach. These courts attempt to account for factors relevant to assessing a debtor’s prospects for repaying their student loans, but they also embrace the subjectivity and moral judgments that lead to inconsistent undue hardship determinations.

Inexplicably, the most objective test is the least popular. The rarely used Bryant test ties undue hardship to federal poverty guidelines. If a debtor’s net income is “at, near or below” the poverty rate or if a debtor’s income is above the rate, but he has sufficiently “unique” or “extraordinary” expenses, the payments represent an undue hardship. Even though the Bryant test is the most objective, it’s still subjective. It’s up to individual judges to determine if expenses are unique or extraordinary.

Even in cases when discharges are granted, there’s inconsistency in the type of relief granted. Some courts only grant full discharges of student loan debt. Others courts grant partial discharges up to the point when the debt subjectively ceases to be an undue hardship. Others, still, take a “hybrid” approach, where they consider individual loans making up the total indebtedness, and discharge some but not necessarily all.

So to summarize, judges define “undue hardship” differently; they use different undue hardship tests; and when undue hardship is found, relief is often dependent upon judicial philosophy rather than the merits of the case. In the end, similarly-situated debtors (and creditors) are treated differently based on the courts in which they find themselves, leaving an irony where inconsistency is the most consistent aspect of the standard’s application.

How To Undo Undue Hardship

My proposed framework eliminates the undue hardship standard. Eligibility under my proposal would be at first dependent upon the type of program in which the student loan debt was incurred. In order to be eligible for discharge of loans obtained in a bachelor’s degree (or lower) program, the debtor must be in repayment for at least five years. For loans obtained in a graduate or professional school program, the debtor must be in repayment for at least ten years.

In addition, the following criteria would apply to all debtors seeking student loan discharge:

  • The debtor must have participated in the federal Income-Based Repayment (IBR) Plan or a similar plan for at least three years for all student loans for which discharge is being sought.
  • The debtor’s “Standard” federal loan monthly payment amount (aggregated over the year) must have been above pre-set maximum debt service thresholds for five consecutive years leading up to the discharge petition.

The purpose of the mandatory repayment periods is to allow debtors an opportunity to realize some benefit from their education and to make loan payments before resorting to bankruptcy. The longer mandatory repayment period for graduate and professional school debtors reflects the favorable employment prospects afforded these individuals, compared to those with lower levels of education. To the extent that the solvency of the federal student loan program would be threatened by this framework, debtors in the best position to leverage their education in the job market should be encouraged to make payments on their loans.

The requirement that debtors participate in an income-based repayment plan for at least three years is intended to ensure that debtors take advantage of options other than bankruptcy before seeking discharge. By reducing the debtor’s monthly payment, such plans may be effective at directing debtors away from bankruptcy.

Pre-set debt service thresholds will be used to determine whether a debtor’s student loan payments, relative to her disposable income, are high enough to warrant discharge. The maximum annual amount a debtor can dedicate to student loan payments is calculated in the following manner:

  • Determine disposable income by calculating the difference between the debtor’s gross income and 150% of the federal poverty threshold for similarly-situated individuals. Gross income is defined as income from all sources, including employment and domestic support.
  • The following student loan debt service thresholds are then applied to the disposable income calculation:

$1-49,999 (disposable income): 20% (debt service threshold)

$50,000-74,999: 22.5%

$75,000-99,999: 25%

$100,000-124,999: 27.5%

$125,000+: 30%

So a debtor with gross income of $40,000 and two dependents (other than the debtor herself) would have disposable income of $12,205—which is the difference between the debtor’s gross income and 150% of the poverty threshold ($27,795) for her family. The applicable student loan debt service threshold is 20%–which means that for purposes of her bankruptcy petition, the maximum amount this debtor could dedicate to student loan payments for the year in question is $2,441 ($203.41 per month), or 6% of her gross income. Student loan obligations above that amount would render the payments, in effect, an undue hardship for that year.

Higher gross income or smaller family size can lead to higher maximum annual student loan payments. For example, a debtor with gross income of $60,000 and two dependents would have disposable income of $32,205 ($60,000–$27,795). The applicable student loan debt service threshold is 20%–which means that for purposes of his bankruptcy petition, the maximum amount this debtor could dedicate to student loan payments for the year in question is $6,441 ($536.75 per month), or about 11% of his gross income.

A debtor with a gross income of $40,000 and no dependents would have disposable income of $23,665 ($40,000 – $16,335). The applicable student loan debt service threshold is 20% — which means that for purposes of her bankruptcy petition, the maximum amount this debtor could dedicate to student loan payments for the year in question is $4,733 ($394.41 per month), or about 12% of her gross income.

In order to be eligible for discharge, the debtor’s monthly payments (aggregated over the year) must exceed the stipulated maximum amounts for five consecutive years. Calculations would be made for each relevant year to account for changes in salary, poverty thresholds, and payment obligations. The Standard repayment plan would be used to determine payment obligations, even if the debtor’s actual payments are set under an income-based plan. Reliance on the Standard plan is premised on the idea that debtors should not be punished for attempting to avoid delinquency by lowering their payments. Monthly payment obligations are usually highest under the Standard plan.

Lastly, this proposal would apply to federal student loans only. I believe that private student loans should be dischargeable to the same extent as other unsecured debt. Private lenders are able to minimize their exposure to credit risks. Thus, these loans should not be given the same special treatment afforded federal loans, the vast majority for which creditworthiness is not considered.

Americans love (and hate) debt. Our reliance on debt as a means of funding personal consumption and as a tool of macroeconomic growth makes over-indebtedness unavoidable. Thus, our economy requires a bankruptcy system that is fair, efficient, and predictable. The looming rise in bankruptcy filings among student loan debtors adds urgency to an already salient problem. We need a better way to determine the propriety of student loan bankruptcy discharges. Let’s undo undue hardship.

(photo: http://www.flickr.com/photos/uofdenver/3770483632/)

Aaron N. Taylor is a professor at Saint Louis University School of Law. His proposal is explained in full in Undo Undue Hardship: An Objective Approach To Discharging Federal Students Loans In Bankruptcy, which will be published in the Notre Dame Journal of Legislation in May 2012. You can follow him on Twitter at @TheEdLawProf.