President Biden intends to take executive action to forgive $10,000 in federal student loans per borrower. Progressives want more — $50,000 in relief per borrower. Critics argue that loan forgiveness spends up to $1 trillion to help high earners at the top more than those struggling at the bottom. The progressives and the critics are both right. Financially strapped borrowers need more than $10,000 in relief while many who would benefit from blanket loan cancellation earn enough to relatively easily repay their student loans.
But what if Biden could forgive $100,000 in student loans for those who truly need it for the same price as the plan to forgive $10,000 loans for every borrower? Biden could go this bold while satisfying his critics through a smarter mechanism: bankruptcy. Rather than forgiving $10,000 or $50,000 indiscriminately, taking executive action to allow borrowers to have student loan debt forgiven through bankruptcy means student loan borrowers who truly need it could find relief.
Bankruptcy offers debtors a “fresh start” by reducing debt obligations. But filing for bankruptcy comes at a cost. Filers pay a hefty fee and often hire a lawyer, at an average cost of $1,500 to $4,000. Their credit ratings take a hit, raising the cost and lowering the availability of credit for years thereafter. Finally, potential filers face stigma, both self-imposed and external. As a result, many people do not file for bankruptcy even though they would benefit financially from it. Even though the coronavirus has caused unprecedented unemployment, only 520,000 people filed for bankruptcy in 2020, down from 750,000 in 2019. Instead of filing for bankruptcy, the financially distressed are relying on stopgap measures such as eviction moratoria and loan forbearance.
Unlike most debt, federal student loans are not typically forgiven in bankruptcy. Unless the government agrees to reduce a student loan, filers must demonstrate “undue hardship” to have their student loans reduced through the bankruptcy process. The Education Department and its private loan servicers contest most attempts to reduce student loans in bankruptcy. Needing to prove to a bankruptcy judge that they “would not be able to maintain a minimal standard of living” without student loan relief, only 40 percent of bankrupt student loan borrowers manage to get their student loans reduced or discharged in bankruptcy.
The irony is jarring. While the Education Department, which has the authority to forgive student loans for borrowers in and out of financial distress, rejects most attempts to reduce student loans by bankruptcy filers, President Biden plans blanket relief for all federal student loan borrowers. Most of the benefits of this forgiveness will be enjoyed by Americans in the top third of the income distribution, many if not most of whom are financially stable. Progressives want $50,000 in student debt relief, a policy whose benefits will be even more skewed towards the well-off. Why are we showering student loan forgiveness indiscriminately when we are so stingy with forgiveness for bankruptcy filers who are plainly in financial distress?
Federal loan forgiveness for people in bankruptcy is the solution, tailoring the executive action to those truly in need. The many hurdles to bankruptcy, including a “good faith” requirement, mean that only those in financial distress can file and benefit from the loan forgiveness. If a tenth of all student loan debtors filed for bankruptcy, which is a very high estimate, then student loan forgiveness can be channeled to borrowers who need it most. Because we are not handing windfalls to the well off, we can forgive more debt for the struggling at the same cost.
Giving strapped student borrowers a good reason to file for bankruptcy offers other benefits. Unlike temporary mortgage or rent forbearance rules, bankruptcy offers a permanent solution, removing a crushing debt burden from people whose livelihoods have been wrecked by Covid-19’s catastrophic impact on many sectors of the economy. What’s more, the prospect of federal student debt relief may help, rather than hurt, other creditors. If student debt gets eliminated in bankruptcy, then other creditors stand a better chance of partial repayment. By targeting student loan forgiveness to those in distress, President Biden’s administration can help heal the economy as well as assisting those most in need.
Yair Listokin is the Shibley Professor at Yale Law School and the author of the new book “Law and Macroeconomics: Legal Remedies to Recession.”