How Does Bankruptcy Affect Outstanding Student Loans?

Many people think outstanding student loans will be discharged by declaring bankruptcy. This is rarely ever true, and even when loans are discharged, they are often only partially discharged. The circumstances of a bankruptcy will ultimately determine how the loans are handled. They are treated fairly similar to any other senior debt. This means assets are sold in order to repay the loans, and remaining sums can be discharged, forgiven or paid through a payment schedule.

Senior Debts in Bankruptcy

A senior debt is the first type of debt to be met in bankruptcy. Examples include mortgage loans, auto loans and student loans. Subordinate debts are second in line. For example, a home equity loan will be subordinate to a mortgage. In a bankruptcy, senior debts are covered first. Subordinate debts are more likely to be discharged. Therefore, student debts are among the first to be repaid. Any federal debts, including federal student loans, are the most senior form of debt. If a borrower took Stafford Loans, Perkins Loans or PLUS Loans, these debts will be repaid prior to even a mortgage debt.

Liquidation to Cover Debt

There are two primary types of bankruptcy for individuals: Chapter 7 and Chapter 13. Liquidation only occurs in Chapter 7. Chapter 13 is a reorganization of debts that basically works like refinancing all loans at once. In Chapter 13 situations, student debt payments are simply restructured so a borrower can afford them. In Chapter 7, however, assets owned by the borrower are sold by the court. The proceeds are used to repay the debts. A borrower does not have control over the process. Instead, a judge orders the liquidation and even orders which assets will be liquidated first. As the assets are sold off, a judge determines when enough proceeds have been made in order to cover the remaining debts satisfactorily.

Remaining Debt Discharged

When the assets do not sufficiently cover all the debts, a judge may discharge the remaining sum. A discharge basically means the debt is erased. However, on the borrower's credit report, the discharge will reflect the debt was not resolved in a manner satisfactory to the lender. Principal sums are rarely discharged. It is more likely for interest to be discharged. This means a borrower will repay the loan in full, but the finance payments will never be made. 

Remaining Debt Forgiven

It is possible a lender will agree to forgive a portion of the debt owed on a student loan. This may seem the same as a discharge, but it carries several unique implications. First, the credit report will indicate the debt was fulfilled. Second, it is more likely a lender will forgive a portion of the principal than a judge will discharge principal debt. Whenever a portion of the principal debt on any loan is forgiven, a borrower may owe taxes on this sum. Loans are technically income provided to a borrower; since they are repaid, loans are not taxed. When the principal sum on a debt is not paid back, it is counted as income.

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