## Tuesday, November 26, 2013

### Student debt and bankruptcy -- impacts on debtors, creditors, and taxpayers

Situation:   A person with \$70,000 in non-dischargeable student loans and \$50,000 in dischargeable credit card debt applies for chapter 13 bankruptcy.  The bankruptcy court has determined that this debtor can afford to repay \$550 per month to these two creditors.   The court is considering two payment options.

The first payment option requires payments to both creditors in proportion to the amount owed.

The second payment option requires that the student continue making current payments towards the student loan with the remaining payment (if any) allocated to the credit card firm.

Both payment plans are slated to last 60 months.

The student has 15 years remaining on her student loan.  The interest rate on the loan is 4.0% per year.

The Department of Education is guaranteeing timely payment of all interest and principal on the loan.  As a result, a court approved bankruptcy plan that reduces payments to the student loan increases both costs and financial exposure for U.S. taxpayers.

Questions:

What is the current monthly payment on the student loan for the student?

What is the balance of the student loan at the end of the bankruptcy period if the courts allows the student to continue making her current payment?

What is the balance of the student loan at the end of the bankruptcy plan if the court requires the bankruptcy applicant to allocate debt payments in proportion to current debt totals?

What is the cost to the taxpayer of a court-ordered bankruptcy plan that reduces payments on student loans?

The monthly payment on a student loan with a balance of \$70,000, a 15-year term, and a 4.0% annual interest rate is \$517.78.  (This is obtained by placing  r=0.04/12, per=180, and PV=\$70,000 into the PMT function.)

The remaining balance on the loan if the debtor is allowed to maintain current student loan payments under the court-approved bankruptcy plan is \$51,141.  (This figure was obtained by placing r=0.04/12, per=60, pmt=\$517, and PV=\$70,000 into the future value function.)

A plan that allocates payments in proportion to the loan amounts would result in a \$320 payment for the student loan and a \$230 payment for the credit card company.  The balance of the student loan after 60 months of the reduced payments is \$64,254.  (This figure was also obtained from the future value function where r=0.04/12, per=60, pmt=320, and PV=\$70,000.)

The court-ordered bankruptcy plan imposes two costs on taxpayers.

First, there is a direct expenditure to lenders because of the reduction in student loan payments.  This expenditure is \$11,820 (60 x (517-320)).

Second, the Department of Education is a guarantor of a larger risky loan.   In my view, the government tends to understate the costs associated with collecting student loans for people who have been forced to delay repayment of their student loans due to a bankruptcy process.

Concluding thoughts:   The impact of the more stringent 2004 bankruptcy reform law on credit card firms, student debtors, and the taxpayer is a fascinating question.   Prior to 2004, most debtors who declared bankruptcy could receive a quick discharge of most consumer loans.    The new bankruptcy procedures place students in a repayment plan that reduces repayment of the student loan.   Bankruptcy was designed to give debtors a fresh start.  However, the new bankruptcy procedures will leave many student borrowers five years older and with more student debt when they complete their bankruptcy plan.

The bankruptcy reform act of 2004 was a great law for credit card companies.  Not so good for debtors and taxpayers.

Readers who are interested in student debt issues and bankruptcy problems might want to look at my post on seven ways to provide student loan debt relief.

http://economicmemos.com/2013/11/27/reprint-of-seven-ways-to-provide-student-loan-debt-relief/