Creating a debt management plan? You probably need to evaluate debt consolidation versus bankruptcy and other options. If you’re paying off debt, there isn’t a “one-size-fits-all” solution. Some choices have a negative impact on your credit score. Others involve lowering the interest rate on your outstanding debt. In this guide, we’ll cover those scenarios and more .
Before you start any plan, speak with a credit counselor. The sections below provide information on bankruptcy, debt consolidation, and debt settlement. A credit counselor can review each of these with you and recommend which option applies best to your situation. Gather your bank statements, credit card statements, and paystubs to prepare yourself for that conversation.
What is debt consolidation and how does it work?
” Debt consolidation” means combining several smaller debts into one large one. The most common form of debt consolidation is using a loan or line of credit to pay off the lump sum of all your credit card balances. Personal loans with a fixed interest rate are the most popular vehicle for this. Personal lines of credit are also popular if you qualify for one.
Another option for debt consolidation is transferring multiple high-interest credit card balances to a lower-interest or zero-interest credit card. Unfortunately, your credit score needs to be excellent to qualify for one of those cards. Your repayment plan will also be shorter because those low-interest offers are typically available for a limited time, aka an “introductory period.”
A third option for debt consolidation is applying for a home equity loan or home equity line of credit (HELOC). The line of credit can provide more flexibility because the repayment period doesn’t begin for several years, but defaulting on it puts your home at risk. A default could also stay on your credit report for seven years, making it difficult to borrow again.
What is bankruptcy and how does it work?
Filing for bankruptcy may seem like a last resort, but there are times when it can be the best option for getting out from under a heavy debt load. Bankruptcy laws are not punitive. They’re designed for the protection of the filer. Better yet, credit reports and debt consolidation loans are not required for you to qualify for a bankruptcy filing.
The two types of bankruptcy for individuals are Chapter 7 and Chapter 13. Chapter 7 bankruptcy wipes the slate clean. To qualify, your household income cannot exceed the state median for your family size, and you need to have minimal liquid financial assets. Student loans cannot be included in the plan. Chapter 7 will remain on your credit report for seven years.
Chapter 13 bankruptcy is a debt restructuring plan. Known as the “wage earner’s plan,” Chapter 13 reorganizes your debt and sets up a reasonable repayment plan that can stretch out over three to five years. The payments are made to a trustee, who then distributes them to creditors based on a schedule determined by the bankruptcy court.
Chapter 7 is obviously the better option if you can qualify for it. If you don’t, filing for Chapter 13 will stop collection calls and other contacts from your creditors. In either case, all your debt obligations will be discharged upon the completion of the plan, even if creditors don’t receive the full balance of what you owe. This differs from debt settlement, as you will see below.
What is debt settlement and how does it work?
The debt settlement industry has spawned some of the shadiest companies in the financial world. They advertise that you can “settle” your debts for pennies on the dollar, which is true, but they fail to mention the damage you can do to your personal credit. Debt settlement is a last resort that should be exercised only if no other option exists for you.
Credit card companies and lenders are willing to settle a debt only after they deem it to be “uncollectable.” That happens after you’ve missed several payments, each of which lowers your credit score. Debt settlement companies will recommend that you “stop paying” your creditors so your accounts can reach the uncollectable plateau. That could take three to six months.
Once the account is far enough in arrears, the creditor will send it to collections. That’s the point when a debt settlement company will step in and make an offer to pay a percentage of what’s owed. That can save you money, but your credit will be damaged, and you also might incur a tax liability. Creditors have the right to send out a 1099-C for the unpaid portion of the balance.
What is credit counseling and how does it work?
Going deeply into debt can usually be avoided with careful budgeting and education on how credit works. That’s where credit counselors can help. They’ll help you evaluate your income and expenses, recommend debt consolidation or bankruptcy options, and work with you to develop behaviors that will keep you from ending up in the same place again.
Many credit counselors work for non-profits that won’t charge you a fee for their services. That differs from debt settlement agencies or loan brokers who make money off your misfortune. Counselors also won’t shame you for reckless spending habits. Their focus is to help you change those and go forward in life with a more enlightened mindset on finance.
Choosing between debt consolidation, bankruptcy, and debt settlement can be difficult for people who don’t have a plan to keep themselves out of debt. Simply vowing to never use credit cards again won’t accomplish that. Credit is a tool. When used properly, it provides extra spending bandwidth when you need it. A credit counselor can help you understand that.