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Ask Kantro: How does bankruptcy affect PLUS loan eligibility?

I applied for a Parent PLUS loan for my son’s education starting this fall. I was turned down due to filing chapter 7 four years ago this October. They said I would not be able to get funds until October of 2010. My lawyer, who helped me file chapter 7 said that he believed this was discrimination and not allowed. Is this true? And if so how can I get around this problem? — John V.

The short answer is that current federal law requires the denial of a PLUS loan if the prospective borrower has had a bankruptcy in the last five years unless there were extenuating circumstances or the borrower obtains a creditworthy endorser for the PLUS loan. If one parent has a bankruptcy but the other does not, the other parent might be able to obtain a Parent PLUS loan approval. Dependent students may obtain increased unsubsidized Stafford loan limits if their parents are denied or likely to be denied a Parent PLUS loan. (Talk to the school’s financial aid administrator about obtaining the increased unsubsidized Stafford loan limits.) Parents who are denied a Parent PLUS loan are unlikely to be approved for a private student loan, though the student might be able to qualify on his or her own.

The long answer is a bit more complicated.

Section 313 of the Bankruptcy Reform Act of 1994 (P.L. 103-394) amended the US Bankruptcy Code at 11 USC 525(c) to prohibit the denial of federal student aid — including loans, grants and work-study — because of a prior bankruptcy or current bankruptcy filing.

However, section 428B(a)(1) of the Higher Education Act of 1965 requires that borrowers of a Federal PLUS loan not have an “adverse credit history”. The regulations at 34 CFR 682.201(c)(2)(ii) and 34 CFR 685.200(c)(1)(vii)(B) define an adverse credit history as having had a “default determination, bankruptcy discharge, foreclosure, repossession, tax lien, wage garnishment, or write-off of a Title IV debt” within the last five years or a current delinquency of 90 or more days on any debt.

As Dear Colleague Letter GEN-95-40 (see question #7 of the attachment) explains, the PLUS loan denial does not violate the US Bankruptcy Code as amended by the Bankruptcy Reform Act of 1994 because the regulations concerning an adverse credit history provide exceptions if the prospective borrower demonstrates that extenuating circumstances existed or if the borrower obtains an endorser for the loan who does not have an adverse credit history. (Each new PLUS loan must be separately endorsed.) The US District Court for the Northern District of Alabama, Eastern Division, found that the definition of an adverse credit history does not violate 11 USC 525(c) in Taylor vs US Department of Education (00-G-3151-E; May 21, 2001). This reversed the decision of the US Bankruptcy Court (96-43284; June 26, 2000).

If a dependent student’s parent is denied a Parent PLUS loan, the student becomes eligible for the higher unsubsidized Stafford loan limits available to independent students. These higher limits provide for an additional $4,000 a year during the freshman and sophomore years and an additional $5,000 a year during the junior and senior years. While these increased limits do not allow the student to borrow as much as a parent could have borrowed through the PLUS loan program, the unsubsidized Stafford loan does provide a lower interest rate.

(The regulations at 34 CFR 682.201(a)(3) and 34 CFR 685.203(c)(1) allow college financial aid administrators to grant the increased unsubsidized Stafford loan limits even if the parents haven’t applied for a Parent PLUS loan if “the student’s parents likely will be precluded by exceptional circumstances (e.g., denial of a PLUS loan to a parent based on adverse credit, the student’s parent receives only public assistance or disability benefits, is incarcerated, or his or her whereabouts are unknown) from borrowing under the PLUS Program and the student’s family is otherwise unable to provide the student’s expected family contribution”.)

Note that if only one parent has an adverse credit history, it may be possible for the other parent to be approved for a PLUS loan. Parents eligible to borrow from the PLUS loan program include both biological or adoptive parents (even if divorced), as well as a stepparent whose income and assets were reported on the Free Application for Federal Student Aid (FAFSA). Legal guardians and foster parents are not eligible to borrow from the PLUS loan program.

If a parent is denied a PLUS loan because of a prior bankruptcy, the parent is unlikely to qualify as a cosigner on a private student loan because most lenders use a 7 or 10 year lookback for bankruptcies. However, if the denial is not due to bankruptcy, it is possible that the family could still qualify for a private student loan. Several lenders who participate in the federally-guaranteed student loan program have incorrectly interpreted the definition of an adverse credit history as involving a 5-year lookback for delinquencies instead of just a current 90-day delinquency. (This is technically not a violation of the regulations, as the regulations at 34 CFR 682.201(c)(2)(iii) permit lenders to adopt more stringent credit underwriting criteria.) This is a stricter standard than is used for private student loans. Also, a student might qualify for a private student loan without a cosigner or ask an aunt or uncle or a friend or other family member to cosign the loan.

Ask Kantro is written by Mark Kantrowitz, an expert on paying for college and publisher of FinAid.org and Fastweb.com, the leading free web sites for information about student financial aid, student loans and scholarships. Write to Ask Kantro at AskKantro@Fastweb.com.