By Joseph Reinke, CFA, CEO of FitBUX
The Trump administration has announced that they are thinking of making it easier to wipe out student loan debt in bankruptcy. The Education Department will begin reviewing this week when a borrower can discharge student loans in bankruptcy as well as seeking public opinion (You can check out the official page here).
Although this may sound like a great thing, this article points out some of the unintended consequences that may arise should student loans become discharged in bankruptcy...
The Effect on Private Loans and Refinancing
Rates on student loans are based on risk. The higher the risk, the higher the interest rate. One item that keeps this rate down for student loans is that student loans are bankruptcy remote (i.e. they can't be discharged in bankruptcy).
If this feature is removed private student loan interest rates will most likely go up and Federal student loan rates may also increase.
On top of that, those that look to save money by refinancing their student loans will most likely see one of two things happen: 1) The interest rates will be higher to make up for the extra risk and/or 2) private lenders will make it a lot harder to qualify for a loan.
It is currently estimated that approximately 10% of student loan borrowers are in default. Let's assume all of them would qualify to have their loans wiped out in bankruptcy. The question to ask is: Does it make sense for the other 90% that are repaying their student loans to face higher interest rates to "make up" for the loss on those choosing bankruptcy?
Will It Even Matter?
I'm not a bankruptcy expert but from my understanding, you have to prove your financial obligations are causing you undue hardship.
For typical loans, this may be straightforward to prove. For example, if you owe 50% of your income every month to a mortgage company for your home loan, then you can easily prove that this debt load will make it impossible for you to "make ends meet". This would be the same should you have a medical hardship and a huge bill etc.
However, when it comes to student loans, as long as income-driven repayment (IDR) plans are available as an alternative, it will be hard to prove undue hardship in my opinion.
Since IDR plans cap your payments at 10% of your adjusted gross income, it will be extremely hard to prove you can't afford 10% of your income to repay your loans...