My last post discussed the $12.73 trillion total household consumer debt gorilla. Recently, my banker told me they were seeing a larger number of individuals consolidating their credit card debt, and other debt, into single bank consolidation loans. He described this activity as the next bubble waiting to pop. We all hate bubbles, especially when they pop. No good comes out of popped bubbles. As the summer heats up, I thought this would be a good time to talk about the difference between debt consolidation, debt settlement, and bankruptcy. Which alternative is better?
Debt consolidation involves lumping multiple debts together into a single, “more manageable” debt. The general idea is a debt consumer would have an easier time paying on one debt than trying to balance many payments, paid on different schedules to different creditors. A debt consolidation loan through a bank has the objective to simplify the repayment process, while simultaneously reducing the number of monthly payments and interest rates. While it sounds good (lower interest rate, lower payment, maintain access to credit) depending on how the debt consolidation loan is structured, a debt consolidation loan may or may not be favorable to the debt consumer. For example, if you use your home or a vehicle as collateral for the debt consolidation loan, you could lose that property if you default on the loan payments. Also, there may be a cross-collateralization clause included in the debt consolidation loan. For example, if you have a car loan through your credit union and then the credit union gives you a debt consolidation loan, it’s not unusual for the credit union’s loan to include a cross-collateralization clause. If you were to default after that on the credit union’s debt consolidation loan, the credit union could repossess your car – even if the car payments are current.
Debt consolidation should not be confused with debt settlement. Debt settlement involves negotiating with a lender to offer a reduced lump sum payment as settlement of a debt owed, usually to a credit card company. A consumer can negotiate a debt settlement with their creditors on their own, or through a credit counseling agency. Debt settlement’s focus is on reducing your debts, while debt consolidation focuses on reducing the number of your creditors down to one. Debt settlement companies typically tell debt consumers to stop paying their creditors and, instead, pay them a monthly payment which may not be all that affordable. Many people think their debt settlement payments are held in reserve, at first, to try and settle the debts. However, the debt settlement company’s contract often states that all money paid goes first to pay their fees. When a consumer starts with a debt settlement company, creditors then commence the debt collection process, which includes harassing phone calls and debt collection letters. Worse yet, creditors may still sue the debt consumer for breach of contract in state court, regardless of the debt settlement process. There is no guarantee a debt settlement will occur. If a debt settlement does occur, there may be significant income tax implications. If a settled debt is less than the amount owed on the debt, the remaining unpaid balance may be considered debt forgiveness. A forgiven debt may trigger a 1099-C issued from the affected creditor to the IRS, making the portion of the settled debt that was forgiven taxable income for that tax year. If you receive a Discharge of debt in a bankruptcy proceeding, however, you do not have any tax liability.
Bankruptcy follows a different path from both debt consolidation and debt settlement. Chapter 7 (liquidation) bankruptcy is an option often used by debtors who have few assets, substantial debt, and too little income to pay their debts. Chapter 7 will eliminate or discharge most debts within about 4 to 6 months of filing. However, a bankruptcy trustee will liquidate, sell, any non-exempt property the debtor may have to pay back the creditors. If your annual income is higher than the median income for your area, you may not be eligible to file a chapter 7 bankruptcy. Chapter 13 (often called debt consolidation bankruptcy) is an option often used by those who want to keep their property, such as homes and vehicles, and those with a regular income too high for chapter 7. Chapter 13 is a restructuring of consumer debt to affordable monthly payments through a chapter 13 plan, usually 36 to 60 months in length.
Which of the three alternatives above is better or worse than the others? A key reason a debt consumer may choose bankruptcy is that it offers considerable protection against creditors through the “automatic stay” that goes into effect the moment a debtor files a bankruptcy petition. The automatic stay freezes collection actions against you, including foreclosures and repossessions, and stops harassing collection calls. Neither debt consolidation or debt settlement offers this type of instant protection.
Bankruptcy also affords the ability for a debt consumer to start improving their immediate financial situation by removing many of the financial obligations. Debt consolidation and debt settlement do not make as strong of an impact on your credit score, for example, like filing for bankruptcy. While bankruptcy may initially hurt your credit, it also gives you a base to start improving your credit.
Whatever choice you make, debt consolidation, debt settlement or bankruptcy, the decision can be difficult. If you’re struggling with debt and are considering filing either a chapter 7 or chapter 13 bankruptcy, an experienced bankruptcy lawyer can help you weigh your legal options and evaluate the alternatives. Please call 813-308-9045 for a free and confidential case evaluation. And remember, whatever path you choose, Press on Regardless!
