If you’re falling behind on debt payments, two of the options you can explore are bankruptcy and debt consolidation. So how will you know which is right for your situation?
First, some definitions:
• Bankruptcy: The legal process of eliminating or reducing the amount of debt owed under the United States Bankruptcy code.
• Debt Settlement: Debt settlement is the process of paying off debt after negotiating with a creditor for less than what is owed. Usually only unsecured debt, such as credit cards and medical bills, is eligible for settlement. This can be done with the assistance of a debt settlement company or, in some cases, an individual may choose to do this on their own.
• Debt consolidation: Taking out a one big loan and paying off smaller loans – usually this means a better interest rate and smaller monthly payment. A third party simplifies the repayment process and reduces the monthly payments and interest rates.
Before comparing the three and deciding which is right for your situation, let’s take a closer look at each of the options
While debt settlement can be good option for people with too much debt and not enough income, there are some very important things you need to know about settlement before taking the plunge.
There are no guarantees that you’ll be able to settle all of your debt. Although debt settlement is a large industry and has negotiated many settlements with many creditors, there is no guarantee it will work.
Debt settlement won’t prevent debt collection activities. As you become delinquent with your creditors, they may continue to attempt to collect their debt, including the possibility of them suing you for the unpaid debts.
You must follow through on your agreement. If something happens and you are forced to miss payments, you could lose the offered settlement amount and be responsible for the remainder of the entire balance.
You will face tax implications on the forgiven debt. You will get a 1099 from the creditors in the amount of the debt that they have forgiven. You will have to pay taxes on that forgiven debt. Seek the advice of a tax advisor to understand if you would be impacted.
And watch out – there are also fees associated with debt settlement and it can have a significant impact on your credit score.
Consolidation of debt involves lumping multiple debts into one single payment. You must take out a new loan to pay off the existing loans that you already have. The idea is that if you have a handful of credit cards, it will be easier to make one payment than to make multiple payments. The hope for debt consolidation is that the new loan will have a lower interest rate than the existing debts.
Bankruptcy – Chapter 7 or 13
Bankruptcy is a legal remedy for individuals (or businesses) who cannot pay their debts. Bankruptcy may be able to eliminate debts all together, as compared to debt consolidation which retains the same amount of total debt for an individual. The truth is debt consolidation loans and debt settlement companies don’t help you get rid of massive amounts of debt. In fact, you could end up paying more and staying in debt longer because of so-called consolidation. Here are some of the most important facts about debt consolidation:
• Debt consolidation is a refinanced loan with extended repayment terms.
• Extended repayment terms mean you’ll be in debt longer.
• A lower interest rate isn’t always a guarantee when you consolidate.
• Debt consolidation doesn’t mean debt elimination.
A Real Life Example of Debt Settlement
It’s common for debt settlement companies to take their fees after a settlement is agreed upon. They may take their entire fee after the consumer accepts the settlement offer or they may take their fee over a series of payments. The amount you’re charged for a debt settlement plan will vary depending on the agency and the size of your debts. Right now, there are two popular fee structures for debt settlement:
1. Pay a percentage of your total debt (usually between 20-30 percent) – Example: you owe $20,000 and the settlement company charges 25 percent. You would pay them $5,000.
2. Pay a percentage of the amount that you save (highly variable) – Example: you settle a $20,000 debt at 50 percent ($10,000) and then owe the debt settlement company $2,000 (in this case, 20 percent of the $10,000 you saved). On top of this, companies may charge an additional monthly fee to be in their program.
The Cost of Debt Settlement:
So, you settle your debt for $10,000 plus $2000 fee, plus the taxes $2,500 (25% of the 10,000 you saved). The cost of debt settlement on a $20,000 debt can be $14,500.
A Real Life Example of Debt Consolidation
Let’s say you have $20,000 in unsecured debt. The debt includes a five-year loan for $10,000 at 12% ($13,347), and a four-year loan for $10,000 at 10%. ($12,174) Your monthly payment on the first loan is $223, and the payment on the second is $254. That’s a total payment of $447 per month.
You consult a company that promises to lower your payment to $322 per month and your interest rate to 9% by negotiating with your creditors and rolling the two loans together into one. Sounds great, doesn’t it? Who wouldn’t want to pay less money per month in payments?
But here’s the downside: It will now take you longer to pay off the loan, and you’ll end up paying about 28% more to pay off the new loan ($27,030). So does this sound like something that would be beneficial for you? Not exactly.
So What Could Bankruptcy Do for Me?
If you have $20,000 in unsecured debt, the amount you pay back is dependent upon how much property you own and how much income you have. In many cases, you will not have to repay any money back to your creditors. If you do have a significant amount of property or are making more than the IRS determination of median income, you may have to pay a portion of the debt back, but it would certainly not be more than the amount owed at the time bankruptcy is filed.
What are some other considerations of debt consolidation and bankruptcy?
Taxes: Debt Consolidation-If some of your debt is forgiven by lenders, the IRS treats the forgiven debt the same way it treats your weekly paycheck: it’s income.
Bankruptcy-If debt is discharged during bankruptcy, it is not taxed as income.
Creditor Harassment: Debt Consolidation-Nothing is in place to stop creditors from continuing to contact you, even if you are making payments through the debt consolidation agency.
Bankruptcy-From the moment you file bankruptcy, it becomes illegal for a creditor who has notice of the bankruptcy to contact you, meaning the unwanted calls will stop.
Total cost: Debt Consolidation-The total cost for debt consolidation can be 15% – 35% of what you owe. Then, any amounts forgiven can be taxed by the IRS at your income tax rate.
Bankruptcy-Bankruptcy filing fees are around $335, plus attorney fees starting at $650.
Time: Debt Consolidation-The repayment time frame can range from between three to five years.
Bankruptcy-The bankruptcy process can last around 3 months.
If you’re considering bankruptcy or debt consolidation, give us a call and we can help you decide what is best for your individual situation.