We All Lose Under Current Student Loan Bankruptcy Rules

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One of the most poignant features of student debt is that, short of paying it off, it's pretty much impossible to get rid of. In 2005, the bankruptcy code was updated to make private loans "non-dischargable" in a personal bankruptcy, meaning that, unlike other private debts, student loans can't be forgiven or written off.* 

This change put private student loans on the same level as federal or state loans and child support payments: totally, non-negotiably sticking with you forever. What is less well-known are some of the consequences the new rule had on the economics of the loan market.

In a nutshell, student loans are more widely available to low-credit borrowers, there's been an enormous surge in loan volume, and loans have become more expensive. And some of the possible results of these changes could have significant economic consequences for consumers in the decades to come.

Unanticipated market changes 
It wasn't supposed to happen this way. Supporters of the law change argued that it would reduce the cost of borrowing by eliminating "strategic borrowers" from the market, or those who take on loans with the expectation of discharging them in a bankruptcy (if that notion makes you raise an eyebrow, you're right on the money: There's no evidence that this was ever actually a problem). Making loans less expensive was supposed to help "good" borrowers have an easier time paying for college.

In reality, the cost of loans actually rose by 0.35% on average, and, perhaps because lenders had more downside protection due to the new rule, there was an enormous influx of borrowers with lower credit scores. In the years following the change, loan volume has tripled, and researchers Xioling Ang and Dalie Jimenez found that 60% of the rise in lending can be directly attributed to the law change.

The result, in other words, is more -- and more expensive -- lending. 

The consequences of leverage 
That might not sound like a problem to you until you consider the long-term costs of being highly leveraged. One demonstrable effect of higher student lending rates is a reduction in the number of small businesses, which are a major source of employment in the U.S. Another potential problem is the future of financial security: If borrowers are spending the first third, or half, or even more of their careers trying to pay off student loans, they might be far less likely to put money toward other financial goals -- like retirement. 

The rise in private lending also comes with a rise in the risk of widespread financial distress. While federal loans come with myriad programs to help borrowers manage their debt payments, private lenders are under no obligation to do this. In other words, while you can't discharge a federal loan, you can find a way to reduce your payment or even, in some cases, have the loan forgiven. Private loans don't come with either benefit, and the combination of higher leverage and a lack of options could work to the detriment of a whole class of private borrowers later on. 

Either way, the policy change had major unanticipated consequences for the loan market itself, and it could have significant long-term effects not only on borrowers but on the economy. Whatever arises, there is growing evidence that loan burdens are becoming a problem -- one researcher refers to current generation of borrowers as the "indentured generation" -- and it's almost certain that the costs will be borne out by all of us in the decades to come. 

*There is technically an exception to this, in the form of an "undue hardship" ruling in a bankruptcy proceeding, but it is so rarely used as to be negligible for the purposes of this discussion. 

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