Student Borrowers Tap a New Path to Loan Forgiveness: Bankruptcy

The increase came after the Biden administration made it easier for student borrowers to apply for bankruptcy by overhauling its guidelines last November. The government now supports borrowers’ use of bankruptcy to eliminate student debt when they meet certain economic hardship conditions. That is a sharp change from the old, far more adversarial procedure that borrowers found confusing and intimidating.

The application numbers remain extremely small, with just 632 borrowers using the new process from last November through September, according to Justice Department data released Thursday. Still, that is an increase from recent levels.

The average annual rate of borrowers using bankruptcy to eliminate student loans was around 480 before the pandemic pause on federal student loan payments. The growth is notable because Americans weren’t required to make student-loan payments until last month.

The department expects those numbers to continue to rise as more lawyers and borrowers become aware of the option. It didn’t provide a number of successful student-loan discharges that have resulted from the new guidance.

Government recommends debt cancellation

“Borrowers are finding it easier to apply for discharge and courts are overwhelmingly agreeing with the Justice Department’s recommendations to discharge student loans in eligible cases," said Associate Attorney General Vanita Gupta.

The bankruptcy policy shift is one part of the Biden administration’s efforts to forgive debts for eligible student borrowers. The White House has made debt forgiveness a central part of its pitch to younger voters.

More than three million borrowers have had $127 billion of their federal student loans flagged for cancellation, despite a Supreme Court ruling in June that blocked relief for millions more student-loan holders. The Education Department has also changed how income-driven repayment programs work for lower-income borrowers, allowing millions to make low monthly payments and have their remaining balances forgiven at the end of a 20 or 25-year plan.

Around 40 million borrowers hold $1.6 trillion in federal student debt. Debt forgiveness is a win for many borrowers, but comes at a cost to taxpayers. Republicans have criticized Biden student loan policies as overstepping his legal authority and using taxpayer funds to support people who should repay the loans they took out.

New procedures started last year

The Justice Department last November released guidelines for prosecutors that set specific requirements for borrowers to prove that they are experiencing economic distress. When a borrower files for bankruptcy, the government calculates whether expenses equal or exceed the person’s income. If so, the Justice Department declares that the borrower cannot reasonably pay the debt, and that the debt should be discharged.

In nearly all cases where that has happened in the past year, judges have accepted the government’s argument and agreed to a full or partial discharge.

The new process assesses whether a borrower’s present inability to pay will likely persist in the future, taking into account factors such as retirement age, disability, long-term unemployment or if the borrower didn’t finish their degree.

The prior system was significantly more arduous for borrowers, and involved the federal government diving deep into borrowers’ financial history in an attempt to prove that they hadn’t demonstrated economic hardship.

Congress wanted to prevent recent college graduates with few tangible assets from declaring bankruptcy when the education they received at least theoretically enabled them to have higher lifetime earnings than if they hadn’t attended school.

That allows the creditor—in this case, the Education Department, which issues federal student loans—to contest claims. The old process was so difficult, it was conventionally assumed that student debts weren’t eligible for discharge at all, bankruptcy experts say.

Limited usage

Borrowers with student-loan debt have long filed for bankruptcy—an average of 250,000 do each year, according to research by Jason Iuliano, a professor at the University of Utah. But without filing the extra documentation related to their student loans, they can only have other debts discharged.

That figure suggests only a fraction of bankruptcy filers are attempting to use the new process. In July, after a freedom of information request from a borrower advocacy group, the Education Department provided a list of 45 cases since the new guidelines were issued in which there had been successful student loan discharges.

“We aren’t yet seeing the systemic change we hope for," Aaron Ament, president of the National Student Legal Defense Network, said in August after the list was released. “They’ve taken important steps, but it’s clear more needs to be done."

Write to Gabriel T. Rubin at gabriel.rubin@wsj.com