There’s an easy way to fix the student debt crisis, and it’s not “cancel all student debt.” The answer may come as a surprise because for many people it sounds like a dirty word. Bankruptcy! While it certainly sounds nice to just wave a magic wand and make the big pile of debt go away , it amounts to a regressive transfer. Robin Hood is stealing from everyone to give to the upper middle class. College graduates make nearly double what high school graduates make. It should be noted that this is ON AVERAGE, though (bear with me and we’ll get to the juicy bits soon enough). To illustrate the fact, we can see median wages with and without a bachelor’s degree:
And median wages overall:
Ok, so the median college graduate is better off than the median high school graduate. What about the people that got screwed over by a low-quality degree, a high-interest loan, or found out their incomes weren’t as high as they had expected when they graduated and are left with a mountain of debt that they simply cannot cover? It turns out we used to have a way of helping people out with too much student loan debt. In fact, it still exists for all other kinds of debt. Bankruptcy is an American institution. It has ominous connotations, but it was created to help people who bit off more than they could chew. It was meant to give risk-takers the chance for a fresh start. It’s certainly preferable to debtor’s prison. Perhaps some people groaning under the weight of their student debt feel like they ARE in a form of debtor’s prison.
Bankruptcy takes many forms in the codex of American law, but personal bankruptcy has two options: Chapter 7 and Chapter 13. If you’re light on assets and heavy on debt, Chapter 7 is probably the best solution. Your assets get liquidated and your debt is discharged. The whole process takes a matter of months (although your credit score will get dinged pretty badly and it will take a long time to bring it back up). If you have enough stuff to make that sound bad but you are light on liquid assets, Chapter 13 is perfect for you. Your debt gets re-organized into manageable payments and you can generally get yourself out of debt within 5 or so years and you get to hold onto your assets. It sounds perfect for a cohort of people that took out big loans and find themselves in a bigger hole than they would have liked, right?
Student loans used to be covered under bankruptcy law just like all other forms of debt. Why can’t we use it now? In 1976, this was changed to combat any abuse arising from conflicts of interest on the parts of the students. They sought to correct for the possibility of abuse by a recent graduate that, just having received their extremely valuable diploma but still asset-poor, decides to declare bankruptcy. Being asset-poor, they could declare Chapter 7 bankruptcy knowing that their debt would be discharged despite the fact that they would be receiving high incomes after graduation. Voila! Free College!
Anyway, back to the change in the law passed in 1976; Congress passed a law requiring 5 years of repayment of your student loans before you were allowed to discharge them in bankruptcy (in other words, wipe the slate clean). A subsequent law passed in 1998 required 7 years of repayment and, finally, the nail in the student-loan-bankruptcy coffin was passed in 2005 disallowing it in nearly all situations. Just how difficult is it, you may ask, to gain bankruptcy protection from your student loans? The name of the required court proceeding should be answer enough (it’s called an adversarial proceeding), but in the off chance you are still curious, prepare yourself. You must meet ALL THREE of the following criteria:
- Student debt would keep you from maintaining a barebones standard of living defined by a demonstration of minimal expenses AND attempts to increase your income in any way possible.
- Additional circumstances must make it likely that these conditions will persist for a significant portion of the duration of your loan. Qualifying criteria include physical or mental disability and a demonstrated maximization of your income potential in your chosen field.
- You must have made “good faith” efforts to repay the loans by making payments, attempting negotiation of a plan, slashing expenses, increasing income, etc.
The odds that a person who does not possess the ability to pay their student loans has the resources required to battle through such a foreboding gambit are infinitesimally small. It’s a disastrous policy that threw the baby (the future of the American college-educated populace) out with the bathwater. Notice something in the chart below? Student debt ramps up into a much larger portion of consumer debt shortly after the passing of that 2005 law. The effect is kicking some of our most vulnerable citizens when they are down.
Here’s the good news: federal loans have a few options for restructuring student debt. Without delving too deeply, their purpose is to help people with a low-income whittle their payments down to 10% of their discretionary income. They are called IBR, ICR, PAYE, and REPAYE, and they all do pretty similar things, but you should do more of your own research before doing anything with them. Regardless, forgiving all federally owned student loan debt would have the effect of adding approximately 7% (a little over $900 million) to net federal debt (financial assets less liabilities), which stands at around $13.5 trillion. Utilization of bankruptcy law is a far better solution in conjunction with programs like those detailed in this paragraph.
Unfortunately, this does not apply to private loans. Private loans often have higher interest rates and are often held by those with lower quality degrees. There is no recompense for someone who is struggling under private loans and, perhaps as a result, lenders have been lax about standards for student loans. Likelihood of repayment has not been taken into account and high school students are ill-equipped to understand the risks they are taking when they apply for these loans. A return of bankruptcy protection for students would force lenders to be more careful when evaluating what the loans are being used for. Students may find it a bit harder to get one of those loans, but this is because they would not be able to take on excessive debt for low-quality degrees. Alternatives exist (MOOCs, community colleges, and trade schools to name a few) that cost less and might be more practical.
The solution to the student loan distortion in the market is to fix the market. The US has the best colleges in the world and our competitive model is a big reason why. Instead of throwing the baby out with the bathwater (again), we should tweak the system to reward the right behavior and punish irresponsible behavior. Let’s bring back bankruptcy. It’s the radically pragmatic thing to do.