Bankruptcy vs debt consolidation? An agonizing choice
Many people who call my office want to know what are the advantages and disadvantages of bankruptcy vs debt consolidation. The reason they – and maybe you – are so interested in this topic is that they have heard drive-time radio ads comparing the two processes. The ads tout the virtues of debt consolidation and imply – or outright state – that the reasons to avoid bankruptcy are compelling. The ads invariably start out with a “hook” line like “Avoid bankruptcy!” or words to that effect.
Bankruptcy vs Debt Consolidation: the steps
You hire a debt consolidation agency. I’ll just refer to the debt consolidator as “Agency” from here on. The Agency collects its fee first, in full or installments. The fee is usually at least a few thousand dollars. The fee charged is often a percentage of what the Agency claims it can save the consumer. The catch is the agency doesn’t start work till all the fees are paid, but maybe you’re not surprised
Once the Agency is paid in full, it begins negotiations with the consumer’s creditors. The hope of the consumer in this scenario is that the creditors will all agree to the Agency’s proposal to consolidate the debt. That amount is variable. The agency proposal will typically be to reduce the principal, waive interest and / or lower monthly payments.
The Agency can’t force creditors to do any of the above. Still, many creditors often do participate. The best result is that the creditors agree to reduce the principal, waive interest and accept lower-than-current monthly payments for a set term. It’s as if the consumer is paying down a loan. One might expect creditors to reward borrowers for all that trouble by reporting the debts reported: “paid as agreed.” Sadly, it doesn’t work that way. Creditors report them “paid as settled.” That remark tinges the borrower’s credit score for several years to come.
The “why” of debt consolidation is a different question. In many ways, it a more important one than the “how.” Many consumers still have a decades-old conception of bankruptcy. It’s one which I myself can still remember from less than thirty years ago when I was in the lending business. It went something like this. “I should avoid bankruptcy at all costs because it ruins my credit forever. I can lose everything I have.” This is a very outdated concept, but it still gets traction with the public. Still, others believe that it’s immoral not to pay all your debts. These painfully conscientious folks often exhaust their savings and sometimes even their retirement funds try to keep current.
Let’s break down some additional “whys”:
Debt consolidators promise an easier process with less impact on the consumer’s credit score. Recent reports from all corners are that consumers emerging from bankruptcy typically see their credit scores recover fairly quickly. Right after filing bankruptcy, some – but not all – filers do experience a sharp drop. (Many filers had an excellent credit score until a traumatic event unexpectedly befell them.) Most people who file bankruptcy rebound and manage their credit very well afterward. They report seeing their scores soar to the mid-to-high 700’s within two years. Customers of a debt consolidation agency are not as lucky. They still have those derogatory marks following them for several more years!
DOES DEBT CONSOLIDATION PROTECT ME FROM CREDITORS LIKE BANKRUPTCY DOES?
Debt consolidators may promise protection from creditors. An agency may informally and temporarily stall a creditor with a well-crafted letter. But the creditor is free at any time to reject any proposal. Worse, the creditor still has the option to pursue all the things they could otherwise have done anyway. Their actions may well include suing you, getting a judgment, then wage garnishments, bank levies, and liens. Bankruptcy is way different, and unique when it comes to protection. It puts up an impenetrable barrier between the consumer and almost all creditors.
Does the IRS treat debt consolidation and bankruptcy the same?
Analyzing bankruptcy vs debt consolidation is especially important when considering avoiding a big tax bill. Debt consolidation can also result in a hefty tax bill from the IRS and from your state taxing agency! When a creditor agrees to reduce the principal of debt, it will issue the borrower a 1099 form for “Cancellation of Debt” income. Debt discharged in bankruptcy, on the other hand, can’t be treated like “canceled” debt and is NOT taxable to the borrower. Imagine convincing your creditors to forgive half of $200,000 in debt. Great! If you’re in the 28% tax bracket, the IRS is going to want $28,000 from you to cover the $100,000 in canceled debt!
So, when does the “bankruptcy vs debt consolidation” question actually favor debt consolidation?
When the consumer meets all three of these conditions:
- He/she cannot file a Chapter 7.
- She must instead file a Chapter 13 (or possibly even a Ch. 11).
- The mandatory Chapter 13 monthly plan payment is more than she can pay.
In Chapter 13, there isn’t much flexibility in the plan payments. Chapter 13 trustees have a statutory duty to force the Chapter 13 debtor to pay as high a monthly payment as the Code will allow. The Bankruptcy Code is not kind in allowing deductions to Ch. 13 filers. Creditors in a debt consolidation plan may be willing to accept much less than the Ch. 13 plan amount. Then, it makes sense to use debt consolidation.
There is an ideal – or at least some times an advantageous – time for debt consolidation. It is a rare time indeed that it gets a better result than bankruptcy, especially Chapter 7.