For years, discussions about student loan defaults have largely centered on unemployment and other financial challenges that made loan repayment difficult for graduates. Federal law precludes student loans from being discharged in personal bankruptcy, so debt relief was impossible for some college graduates to achieve. Help appeared to have arrived in the form of a federal program that allows borrowers with low incomes to make reduced monthly payments. After 25 years of reduced monthly payments, the program allows forgiveness of any remaining balance; however, the program may create serious financial issues for unsuspecting graduates.


The terms of the income-based forgiveness program sound inviting to a graduate who comes out of school full of hope and dreams — but finds instead a struggling economy, unemployment and overwhelming debt. Today, each college student leaves a graduation ceremony with a degree and student loan debt that averages $26,000.


Graduates taking advantage of the government’s offer of reduced payments may be in for a surprise as their debt balance increases. When the student pays less than the full interest on the loan each month, the unpaid interest is added to the principal. After making payments for 25 years, the graduate is not still free of financial obligations. The IRS treats the forgiven debt as income on which the former student must pay income taxes, this is also known as cancellation of debt income.  At the very least, IRS debt eventually may be able to be discharged under bankruptcy, but that is a topic for a whole essay in and of itself.


Another option would be Chapter 13 bankruptcy, which essentially allows deferment of student loans during the 3-5 year repayment period of the Chapter 13 case.


An individual struggling with financial challenges brought on by unemployment, medical expenses and unexpected life changes can consult with a bankruptcy attorney about options to eliminate debt or structure a plan for manageable payments. The attorney will explain how student loan debt is treated differently than other forms of debt in a personal bankruptcy and can review an individual’s finances to present the best available option for overall debt relief.


Source: Business Insider, “How student loan ‘forgiveness’ can lock law grads in debt bondage,” Erin Fuchs, Nov. 8, 2012