Bankruptcy vs. Debt Consolidation and Debt Settlement
People facing serious financial issues and debt problems have several options available to find relief. Bankruptcy offers the most effective means of getting a handle on debts or getting rid of debt altogether, but it’s not the right option for all situations.
Other options available include debt settlement (or debt negotiation) and debt consolidation.
The following is a description of debt settlement and debt consolidation work and the pros and cons of each.
How Debt Settlement Works
Debt settlement is a means of negotiating with your creditors in order to settle the debts owed for less than the total amount. Usually, it is possible to settle debt for around 40 to 50 cents on the dollar, but requires some rather risky steps be taken. Here is an outline of how the typical debt settlement approach works:
1. Stop Making Payments to Your Creditors
In order to begin the negotiation process with your creditors, you must be behind on your payments, usually by several months. The reason is simple; if you are up to date and making payments, why would your creditors be willing to negotiate with you? They wouldn’t; they would much rather just keep collecting your monthly payments.
Once you stop making payments for some time, creditors will be more willing to negotiate a settlement amount. They would rather get 50 cents on the dollar then have to sell the account to collections or start filing lawsuits to get their money.
2. Funnel Money into an Interest Bearing Account
In order to settle your debt, you will need to have a lump sum of cash to offer in return for the lender forgiving your debt. Many lawyers that offer debt settlement services will set up a trust fund in the name of their client into which they make monthly payments to build up the settlement offer. This will take time--a year or more is necessary for most people to have sufficient funds for a settlement payment.
3. Deal with Creditors
After a month or two of not making payments, the letters and phone calls will begin. At first, they may be benign “reminder” letters and calls, but it won’t be long before threats of legal action start coming.
4. Fend off the Lawsuits
Sooner or later you will be served a notice of a lawsuit (or lawsuits). If you ignore these you can be held in contempt of court. You are going to have to respond, so you may want to talk to a lawyer to protect yourself.
5. Begin Negotiations
Once you have acquired enough case to make an offer, you must begin negotiations with your creditors. Often, a good starting point will be around 30 percent of the debt--any less than that and they won’t take you seriously and simply pursue legal action to its end. A realistic amount for you to end up paying is around 40 to 50 percent.
Risks of Debt Settlement
The main risk with debt settlement is that your creditors are under no obligation to accept any settlement. They are legally entitled to 100 percent of what you owe plus late fees and interest. If they really wanted to, they may be able to go ahead and garnish your wages or place a lien on your property. That is why negotiations must be done carefully and lowball offers should be avoided.
Tax and Credit Pitfalls of Debt Settlement
The two other downsides to debt settlement is the impact on your credit score and the fact that you will be liable to pay taxes on any forgiven debt. When debt is “charged off” or forgiven, it essentially means the creditor(s) felt it couldn’t be collected and wrote it off as an expense. There are two consequences of this write off:
- The charge off will go on your credit report, essentially saying you didn’t repay all your debt. This will have a significant negative effect on your FICO score.
- Since the creditor wrote off the debt as an expense, it means, in the eyes of the IRS, it must be income for someone else. For tax purposes, you will be “1099’d” and will need to pay income tax on the forgiven debt. This is something that comes as a shock to most people (keep that in mind).
What about Debt Consolidation?
Debt consolidation is a great option for people who still have decent credit, regular income and a reasonable debt to income ratio, meaning they make enough that they could pay off their debt given a reasonable interest rate.
If you are stuck with a lot of high interest debt, such as credit cards and payday loans, and you have a good, reliable income, then consolidating debt may be a great option. The idea behind debt consolidation is that you get a low interest loan, preferable under 5 percent, and use the money to pay off all your other debts. The benefit is that you can reduce you interest rate by 75 percent in some cases.
Homeowners Options
For homeowners with some equity in their house, a HELOC (home equity line of credit) can often be obtained at a very low interest rate. This is perfect for debt consolidation because once approved, it’s readily available and you only borrow how much you need to cover all your other debts. Having one payment instead of many makes your repayment much more manageable, not to mention it can save you lots of money in interest costs.
Downside to Debt Consolidation
Debt consolidation is excellent for those that can afford it. It has no impact on your credit score, no tax issues, and saves you money. The downside is that compared to bankruptcy and debt settlement, it’s just not that effective for people who are truly insolvent.
Debt consolidation is really only an option for people who just want a lower monthly payment. If you are truly in financial distress, it probably won’t be much help.
A Quick Comparison
|
| Bankruptcy | Debt Settlement | Debt Consolidation |
| Effectiveness of Relief | Most effective | Potentially very effective | Least effective |
| How Long Does it Take? | Chapter 7: 60 to 90 days Chapter 13: 3 to 5 year payment plan | 9 to 18 months | Depends on the level of debt |
| Tax Consequences | None | Charged-off debt is taxed as income | None |
| Effect on Credit | Impacts credit negatively | Impacts credit negatively | No impact |
| Main Benefits | Most debts are eliminated and debtor is protected by bankruptcy court | Can eliminate around 50 percent of debt | Very low risk and no impact on credit score |
| Main Drawbacks | Main drawback is the impact on credit score | Impact on credit score, tax consequences, potential lawsuits by creditors, may not work at all, high risk | Not very helpful for people with large amounts of debt |
Bankruptcy is best for those individuals and business owners that have a significant amount of debt--more than is realistically repayable. Income is irrelevant in most cases as bankruptcy offers different options for debtors with varying levels of income.
Debt settlement may be best for people with significant unsecured debt, regular income and some need to avoid bankruptcy.
Debt consolidation is best for debtors that have a good debt to income ratio, but just need to reduce interest rate and monthly payment on debt.
Debt Consolidation and Debt Settlement Companies
Be very careful about using and debt settlement, debt negotiation or debt consolidation companies, especially those you see on TV or on Internet advertisements. These companies often charge very large fees and offer very little value.
If you want to start a debt settlement program, talk to a bankruptcy or debt settlement lawyer. These attorneys can often do a better job at less expense to you. Not to mention, when a bankruptcy lawyer negotiates on your behalf, creditors are more open to settle because they know if you file bankruptcy they will get no money at all.
If you think consolidation is your best option, talk to your banker. He should be able to help you get into a low interest loan so you can pay off your debts and save some money.
Next Steps
3. Deciding to File for Bankruptcy
4. What Bankruptcy Can Do
5. Your Property in Bankruptcy
Thinking About Bankruptcy?
