What Happens to Your Student Loans during Bankruptcy?

It is not likely you will have the sum of your student loans discharged in bankruptcy. Many borrowers think declaring debts will remove their entire obligation to repay student debts. In reality, there are few situations where the principal sum will be forgiven. Interest may be forgiven on student loans depending on the type of bankruptcy protection you are granted and other factors. There are two primary types of personal bankruptcy: Chapter 7 and Chapter 13. Each type of bankruptcy will have different procedures for student loans.

Chapter 7 Bankruptcy

Chapter 7 is also known as liquidation. This is an absolute form of bankruptcy that is not available to all persons. Only those individuals who can no longer afford to meet their debt obligations based on certain criteria will qualify for this most severe form. Debts will be paid according to their seniority, which is set by the lien order and not by the borrower himself or herself. A judge orders assets to be liquidated and debts to be repaid. Student loans are typically senior debts, meaning they will be among the first debts ordered to be repaid in a bankruptcy. You will have little control over this process.

Chapter 13 Bankruptcy

Chapter 13 is a less severe form of bankruptcy that allows you to maintain ownership of a certain amount of assets. In this case, you submit a repayment plan that will you to meet debt obligations according to new terms. The lenders will have to agree to the new payment terms. In most cases, this form of bankruptcy is more favorable for both lenders and borrowers. You will have more control in this type of bankruptcy, and you will be actively involved in determining the best arrangement for repaying the debts.

Discharge in Bankruptcy

In a Chapter 7 bankruptcy, some student debt may be forgiven or discharged. As previously mentioned, this is rarely the entire principal sum. Instead, interest charges are more likely to be forgiven. A judge will have to determine that repaying the debt in full would be financially detrimental to you. The judge will determine an appropriate settlement amount for the principal. It is important to realize there may be an outstanding tax obligation on any forgiven principal debt. Forgiven principal debt may be considered a form of income by the IRS. You will need to report the debt forgiveness and pay taxes on the sum in most cases.

Debt Restructuring in Bankruptcy

It is more likely for student debt to be restructured than forgiven in bankruptcy. In this case, you will have your monthly payments adjusted to an amount you can afford. If you have no salary, the judge may allow for a period of deferment until you are able to secure a salary. If debts have gone into default, the judge may order a period of forbearance for you to attempt to bring the loans current. In any case, you will still be on the hook for the loan sum for many years to come. However, you may still have a certain portion of the debt removed. For example, fines and penalties assessed on late or missed payments may be forgiven.

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