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Money Management Center
Mike Deane Nov 20, 2014
If you’re in over your head when it comes to debt, you may have two options that are open to you: debt settlement and personal bankruptcy.
Debt settlement occurs when you owe more debt than you can ever pay, so you pay a part of that debt you owe to the company rather than the entire amount. This can be accomplished by approaching the company on your own and explaining the situation, or by hiring a lawyer or debt settlement company to act on your behalf. The latter two options will involve more costs, so if you only have one or two debts you can’t keep up with, it’s best to first contact the company on your own and see if an arrangement can be made.
Debt settlement can take the form of a lump sum, one-time payment that the company will accept instead of the larger debt you would be paying back over a period of time; or a decreased total debt, which can still be made through monthly payments. Companies will accept less if they are concerned that this is the only money they will be able to get back from a non-collateralized loan. Non-collateralized means that the company does not have the means to get anything else from you—a car or house, for example, if the company loaned you money to buy one of these things—so they will accept a smaller amount rather than risk not getting any of the debt repayment.
If you were to file for bankruptcy because of overwhelming debt, the creditor would most likely receive nothing, so in certain circumstances they accept that some smaller amount of money is better than nothing at all.
Be sure to keep on top of your finances with an emergency fund; find out more in Why You Need An Emergency Fund – And How To Build One.
Debt settlement is used when you are far behind on payments and can’t afford to keep up with the monthly payments going forward. It should be treated as a last resort, however, and should only be used when there are no other options. If you’ve fallen behind on payments, contact the company and let them know the situation and the amount you can afford to pay per month.
Be sure to consult the Federal Trade Commission site for more information on coping with debt.
Debt settlement companies contact the companies you owe on your behalf and negotiate a smaller debt repayment. As they say, there is no free lunch, and you will have to pay the debt settlement company a fee for this service.
When you call one of these companies that are hyping their service, know that starting as of October 27, 2010, for-profit companies that sell debt relief services over the telephone may not charge a fee before they settle or reduce a customer’s credit card or other unsecured debt. Unfortunately, many consumers still get hit with numerous fees that have resulted in no debt relief. When choosing a debt settlement company, make sure you go over the fee structure, and understand what they offer, how much it costs, and make sure you don’t pay anything until you’ve seen the debt settlement results.
You should also consult Bankrate.com’s list of 5 Debt Settlement Do’s and Don’ts.
There are some debt settlement companies that can help, but clients would likely have to be six months or more behind in any payments they have made.
Consumers having trouble with debt should make two appointments: one with a credit counselor, and one with a bankruptcy attorney. You can find credit counselors on the National Foundation for Credit Counseling at NFCC.org. They can also refer you to a bankruptcy attorney in your area.
A credit counselor can help you by contacting and negotiating with creditors, and by setting up a debt management plan for you. A credit counselor would take stock of your debt and try to work out a repayment plan so that you don’t have to ruin your credit.
Avoid the temptation of the debt settlement companies’ catchy ads that promise little out of your pocket and debt that will be instantly wiped away. If you are advised to use a debt settlement company, be sure to ask the right questions and understand the FTC rules about debt settlement. Also make sure you understand how much the service is going to cost and how long you’ll have to wait before you see results.
The Downside of Debt Settlement
Before feeling any pride in thinking you may have beaten the system by reducing the amount owed, realize that potential lenders view your credit history to see how well you have managed credit in the past, since it will likely be a fairly good indicator of how you will manage it in the future. Bad credit history can easily remain on your records for 5-10 years. Who’s going to lend you money at any reasonable rates then? You may think that you will never need to buy anything substantial again, but what about anything else, like a credit card, which you will almost certainly use at some point in the future.
Learn more about how to fix your credit after you’ve damaged it: How To Quickly Repair Your Credit.
Personal bankruptcy is usually the last option for those in so much debt that they can’t hope to pay them off – even with a debt repayment plan and some kind of debt forgiveness. Though bankruptcy has a large effect on your credit score, and affects whether you’ll be extended credit or a mortgage years into the future, it usually comes at a point when your credit score has already received a beating from unpaid debts.
In this light, bankruptcy isn’t the huge credit destroyer people think of it as, because if you’re considering bankruptcy, chances are your credit score is already on the low side. It’s hard to know when bankruptcy is actually the right option, and in some cases, it actually is the best financial move you can make.
There are two types of personal bankruptcy: Chapter 7 and Chapter 13. The table below offers a brief summary of the key differences between the two types of personal bankruptcy – read on for more details about each one.
|Chapter 7||Chapter 13|
|Type of Bankruptcy||Liquidation of assets||Debt adjustment|
|Who Can File?||Individuals and Businesses||Individuals only, including sole proprietors|
|Eligibility Restrictions||Income must be low enough to pass the Means Test||No more than $383,175 of unsecured debt, or $1,149,525 of secured debt|
|How Long Does it Take?||Usually 3 to 5 months||Usually 3 to 5 years|
|Advantages||Quickly discharge most debts||Allows debtors to keep their property|
|Disadvantages||Trustee can sell nonexempt property||Must make monthly payments to the Trustee|
In Chapter 7 bankruptcy, a trustee is appointed to assess your debts and assets and determines what can be paid to your creditors, and what debts will be canceled. This is a liquidation bankruptcy, so you should understand how all of your debts work, and what assets and wages creditors are legally allowed to go after according to the contract you had with them. The trustee will decide which of your assets are exempt or non-exempt from the bankruptcy proceedings. Exempt assets you will be able to keep and non-exempt assets will be liquidated in order to pay back your creditors.
What Happens When You File for Bankruptcy?
Once you file for bankruptcy, creditors will stop contacting you, and will wait for the “creditors meeting,” which will happen weeks after you file. At this meeting, the trustee will go over your assets and debts to these creditors, and will decide what can be paid back and what must be forgiven. Exemptions are different for each state, and there are also federal exemptions. Some states will allow you to decide between whether you want to use the state exemption or the federal exemptions. Most states and federal exemptions allow you to keep certain values for your house, car and some part of your other assets (some clothing, some jewelry, pension, etc). Look into what is exempt in your area, so that you know how much to expect to lose once your finances are put in the hands of a bankruptcy trustee.
There are certain debts that are not discharged, no matter what the bankruptcy decides is exempt or non-exempt from repayment. The non-dischargeable debts include: student debt (to a certain degree), child support and alimony, income taxes incurred in the past three years, recent debts incurred for luxury items, and other debts that may be deemed as non-dischargeable. Keep these in mind, too, if you’re planning on filing for bankruptcy – what debts will you actually be getting rid of?
In Chapter 13 bankruptcy, your assets are not liquidated and you are required to pay back your debts over a specific time period. This bankruptcy is known as “reorganization” bankruptcy and involves you paying back your debts through your income. Your debts and income are assessed to make sure that this is possible over the 3-5 year repayment period.
The repayment plan (created by the bankruptcy trustee) will state what debts must be paid in full, and what debts will be paid in part. There are limitations on this type of bankruptcy, and you must realistically be able to pay back your debts in a given time period.
Be sure to read over the Federal government’s Bankruptcy Basics guide.
Bankruptcy’s biggest effect is that it lowers your credit score, and can affect your credit score for up to a decade. You are not allowed to apply for a mortgage within two years of filing for bankruptcy, and once you are allowed, the terms will be very expensive. As well, bankruptcy can affect your employment prospects; employers are not allowed to ask you if you’ve gone bankrupt, but they are allowed to check your credit score to determine your reliability and the risk that you will steal from the company.
When Is Bankruptcy the Best Option?
Obviously, bankruptcy is never a good option, but if you look at all of the information above, at some point it may be the only option left for you. If you have already visited credit and debt counselors, and you are unable to come up with a realistic plan to pay down your debts, and you’ve talked to all of your creditors and tried to come up with payment plans or debt forgiveness, then bankruptcy might be the only option you have left. Just make sure you understand what you’ll be giving up.
The best thing to do is to find a bankruptcy attorney to figure out if filing bankruptcy protection is your only solution. The attorney should go over several different bankruptcy options that you can consider.
If you can avoid it, don’t go down the debt settlement road or file for bankruptcy. Make adjustments to your situation before a financial fire gets started. At the end of the day, people make mistakes with their money, but the lesson is to remember how you got there and remind yourself often that you will never want to go through the process again.
Swimming against the debt tide can be a bad habit that will only get you in trouble repeatedly; you must be determined to get back on the right track if you are ever going to rebound successfully in your personal life and/or business.