Bankruptcy is a legal proceeding that provides financial relief for consumers who cannot repay their debt. Many types of debts can be forgiven in bankruptcy, including credit card debt and medical debt. But certain types of educational benefits, such as federal student loans, cannot be discharged in bankruptcy.
In previous bankruptcy cases, it was unclear whether private student loans were dischargeable loans — until July 2021, when a federal court ruled that private student loans are not considered qualified higher education expenses under the U.S. Bankruptcy Code.
Discharging private loans in bankruptcy may provide much-needed respite for debtors who can't meet their debt obligations, but bankruptcy has a lasting impact on an individual's finances and credit score. It's important to consider the alternatives before resorting to bankruptcy.
If you're having trouble making your private student loan payment, then refinancing may be the answer. By refinancing your college debt to a lower rate, it may be possible to reduce your monthly payment so you can avoid defaulting on your loans.
Private student loan refinance rates are hovering near historic lows. To lock in your interest rate, get preapproved for student loan refinancing on Credible.
Private student loans can be forgiven in bankruptcy, federal court rules
The Bankruptcy Code prevents certain types of debt from being discharged in bankruptcy proceedings, including debt incurred as part of an "educational benefit." But private student loans don't fall into this category, according to a July 2020 court ruling.
A New York-based federal appeals bankruptcy court ruled in favor of a debtor whose private student loans issued by Navient were discharged in bankruptcy. The ruling further defines the meaning of an "educational benefit," setting a precedent for private loan holders who want to discharge their student loan debt in the future.
For example, a "scholarship" for a student-athlete need not be repaid if the recipient remains on the team; similarly, a "stipend" is a payment that is conditioned on the recipient’s performance of services and generally need not be repaid. The defining characteristic of a loan, by contrast, is an unconditional obligation to pay it back.
"Educational benefit" is therefore best read to refer to conditional grant payments similar to scholarships and stipends.
But just because it may be legal to discharge these debts in bankruptcy doesn't mean it's advisable. You should weigh the implications of this drastic debt relief measure and consider the alternatives, like refinancing.
Private student loan refinancing may offer a more favorable alternative to bankruptcy
Chapter 7 bankruptcy, also known as liquidation bankruptcy, essentially allows you to have your private student loan debt forgiven, but it comes with a few major drawbacks:
- You're typically forced to liquidate luxury assets, such as a vacation home or second car, as well as financial assets like cash in savings, stocks or other investments.
- Your credit score will take a major hit, which will make it harder to get approved for financial products with a low interest rate.
- You may earn too much money to file for Chapter 7, depending on your household income and a bankruptcy means test.
- You may have to hire a bankruptcy attorney, and attorney fees can add to the upfront cost of filing for bankruptcy.
Bankruptcy will remain on your credit report for 10 years, and it will have an immediate negative impact on your credit score. With bad credit, you'll receive less favorable offers on financial products like mortgages, auto loans and credit cards — if you can qualify for them at all under these circumstances.
On the other hand, private student loan refinancing may offer a way to make your college debt more manageable without leaving a damaging mark on your credit history. Private student loan refinance rates are near historic lows, which means it may be possible for you to qualify for a better interest rate on your debt and lower your monthly payment. Under a more affordable repayment plan, you may be able to keep your finances afloat without defaulting on your loans.
You can browse your estimated interest rates without a hard credit inquiry on Credible to determine if refinancing can help you stay current on your private student loan debt.
How to decide if student loan refi can help you prevent bankruptcy
It can be difficult to budget for private student loan payments, especially in times of financial hardship. Bankruptcy is one way to deal with unmanageable debt, but it's not your only option. You may be able to cut your monthly payment by $250 or more by refinancing your private student loan debt to a longer repayment period, according to data from Credible.
It's easy to see how much you can save on your monthly loan payment by refinancing. First, make sure you have private student loans, since refinancing federal student loans makes you ineligible for protections like undue hardship deferment and qualified education loan forgiveness. Then, follow these steps:
- Gather documents for your current student loans to find your interest rate and loan amount.
- Get prequalified to see your new estimated interest rate.
- Enter your loan information in a student loan calculator to determine your monthly payment.
Once you have an idea of your new monthly student loan payment, you can decide if the difference is substantial enough to keep you out of default.
You can compare estimated rates across multiple refinancing lenders at once on Credible without affecting your credit score, so you have nothing to lose. Make an informed decision about your current financial situation by exhausting all your options before considering bankruptcy.
Have a finance-related question, but don't know who to ask? Email The Credible Money Expert at email@example.com and your question might be answered by Credible in our Money Expert column.