Dealing with Debt

Debt Settlement

You may have seen advertisements for debt settlement companies on television.  They often make extreme promises, such as eliminating all of you debt, that may sound too good to be true.

Debt settlement will almost always come with a cost.

• First, debt settlement companies generally charge a fee for arranging to settle your debts with creditors.  The reason it is called a settlement is the amount they offer to pay your creditors is often less than you owe.  The fee they charge you may be based on the amount “forgiven” by the creditor.
• Second, the debt settlement company may instruct you to stop paying your debts and stop communicating with your creditors while they negotiate your settlement amounts.  This may result in late fees, penalty interest charges, and collection efforts on some debt, causing the overall amount of debt you owe to grow.  This is a potential cost in addition to the fee associated with debt settlement.
• Third, when your debt is settled, you may end up owing income tax on the portion of the debts forgiven.  What you owed and no longer have to pay is now seen as income from the perspective of the IRS.  You will likely receive a 1099 for the portions of the debt forgiven.  This is another cost of debt settlement.
• Additionally, debt settlement is often reported as “settled” on your credit reports.  This is generally considered negative information on your report, and may adversely affect your credit scores.  When your credit reports are negative or credit scores drop, you often end up paying more for credit, services, insurance and may end up disqualifying yourself from jobs, promotions, or apartments.  This is another potential cost of debt settlement.

While some creditors and debt collectors will agree to settlements with debt settlement companies, many will not negotiate the amount they will accept.  Instead, they have standard policies about how much principal they will forgive when you haven't made payments for a certain period of time. This means debt settlement companies usually can't get better terms than you could get by talking to your creditors yourself.

Finally, be aware of debt settlement scams. 

Debt Consolidation

If you are juggling many debts, you may feel overwhelmed.  It can be hard to manage your budget and keep up with multiple debt payments.  Some people turn to debt consolidation as the answer.

Debt consolidation involves taking out one loan and paying off all of your debts with that money.  This leaves you with one payment that is generally less than the other debts combined.  For some people, this is easier to manage.  And in some cases, it can more affordable.

But, debt consolidation loans need to be approached with caution. Often:

• You will pay more in total interest with a debt consolidation loan.
• You may not have solved the underlying issue that caused you to get into debt in the first place.
• Having one payment through the debt consolidation loan may psychologically free you up to take on more debt and you could end up worse off.

Some financial educators and advisors recommend steering clear of debt consolidation loans.  If you feel debt consolidation may be right for you, follow these steps:

• Ask about debt consolidation at your current bank or credit union.
• Figure out if debt consolidation will take you more time to pay off than if you just continue paying your debts independently.
• Figure out if debt consolidation will cost you more in terms of total interest paid.
• You can use a debt consolidation calculator to help you understand if a debt consolidation loan will help you.  The calculator should tell you whether continuing to pay the debts independently or through a consolidation loan would be faster and less costly in terms of interest and fees.

Debt consolidation loans advertised on television and on the Internet should be avoided.  They often charge higher fees and interest and may end up costing you a lot more than paying your debts  individually.

Finally, it is also important to understand how you got into an unmanageable amount of debt and take steps to get your lifestyle in line with your income.  You can start by tracking your spending.  Consider developing a cash flow budget once you understand how you spend your money.

 

Bankruptcy

Sometimes paying off the debts you owe is just not possible.  Being overwhelmed by debt can be stressful and scary.  Bankruptcy is an option to help people deal with this situation.

Bankruptcy is a legal process through which all or a portion of existing debts are reduced or eliminated under the protection AND supervision of bankruptcy courts.

For consumers, there are two kinds of bankruptcy, named after the section of the bankruptcy code:

• Chapter 7
• Chapter 13

Under Chapter 7 bankruptcy, the individual surrenders assets that are not exempt to the court. Debts are paid from these assets.  Debts are then discharged whether they are paid in full or not.  Chapter 7 bankruptcy is sometimes called liquidation bankruptcy or “walk away” bankruptcy. With Chapter 7 bankruptcy, you are giving up your non-exempt assets, but protecting future income from debt payments.

Chapter 13 bankruptcy if often called reorganization or payment plan bankruptcy.  This form of bankruptcy allows an individual to repay his or her creditors through a payment plan negotiated by the courts and under the supervision of the courts.  Creditors generally look more favorably on Chapter 13 bankruptcy.  Creditors see an individual as trying to pay what he or she owes.  With Chapter 13 bankruptcy, you are protecting your assets, but tying up future income through repayment plans.

Bankruptcy procedures were reformed in 2005, creating an income eligibility requirement for filing Chapter 7 bankruptcy. This is called the means test. The goal of the means test is to determine whether you have enough disposable income leftover to pay at least a portion of your debt.  If your income is less than the median income of your state based on your household size, you qualify for Chapter 7 bankruptcy.

If your income is above the median income, the means test is more complicated.  The higher your disposable income, the less likely you will qualify for Chapter 7.  If you do not pass the means test, your case will be converted to a Chapter 13 bankruptcy or dismissed.

There are three exceptions to the means test for Chapter 7 bankruptcy. If:

• More than 50 percent of your debts are non-consumer debts, or business debts.
• You are a disabled veteran and your debts were incurred while on active duty or engaged in homeland defense activities.  You must have a disability rating of at least 30 percent.
• You are a military reservist or National Guard member.  The exception applies to the period of time you are on active duty for a minimum of 90 days and 540 days after that.

Additionally, there are the pros and cons of bankruptcy to consider:

Pros of Bankruptcy

• Gives you a fresh start financially
• Many unsecured debts may be forgiven or handled through an affordable payment plan
• You may be able to keep many of your assets, depending on state law
• Once you file for bankruptcy, collection efforts must stop
• If a creditor continues to try to collect the debt, it could be cited for contempt of court and ordered to pay damages
• Since you can only file for bankruptcy every 8 years, you are a good risk to a lender because you cannot repeat the process
• You cannot be fired from your job solely because of a bankruptcy filing

Cons of Bankruptcy

• Bankruptcy can remain on your credit report for up to 10 years; this is a negative on your reports and will make your scores drop
• The credit you will be approved for is likely to be more costly

Finally, filing for bankruptcy costs money.

The filing, administrative, and trustee surcharge fees for Chapter 7 bankruptcy are currently $335.  The filing and administrative fees for Chapter 13 bankruptcy are currently $310.  These fees do NOT include fees you may have to pay for legal representation, credit counseling, debtor education, or certificates from credit counseling and debtor education providers.

You will also have to pay for credit counseling before you file for bankruptcy and debtor education after the petition for bankruptcy is filed and before your bankruptcy case is discharged.  If your household income is below 150 percent of the federal poverty limit, you automatically qualify for a fee waiver for these services.

You must present the court with a certificate for both credit counseling and debtor education.  You must also use an approved credit counseling provider and an approved debtor education provider.