Is Bankruptcy Right for Me? Alternatives to Bankruptcy
Filing for bankruptcy is not a decision that should be taken lightly. Although bankruptcy may seem (and often is) the quickest, easiest, and least-expensive way to end your financial problems, it also has its consequences, probably the worst of which will be a severe hit to your credit rating.
Let's face it: When you file for bankruptcy, your credit will be in the toilet for a while. In fact, bankruptcy is like the atom bomb of negative entries in a credit report. Nothing else even comes close (with the exception of repossession, and only if you're applying for a car loan). So it's wise to at least consider the alternatives prior to making the decision to file.
On the other hand, some people who are considering filing for bankruptcy already have such horrible credit that bankruptcy might actually improve it. It can be a tough call. So before making a decision, I strongly suggest that you consult with a bankruptcy attorney and consider all of your options.
That being said, here are some alternatives that I urge you to consider before filing.
Bad credit debt consolidation boils down to taking out one big loan to pay off a bunch of smaller loans. Sometimes, this is the best option, especially if you become aware of your financial crisis early on while your credit is still relatively intact, or if you have equity on a home that you can borrow against.
One example of a person for whom debt consolidation might be a good idea would be someone who lost his or her and had to take a lower-paying job, and is having trouble making the payments for the debt incurred while he or she was making more money. A debt consolidation loan that reduces his or her monthly payments, even if it stretches the debt out over a longer period of time, may be enough to get this person through the tough times.
Another example would be someone who lost his or her job and used credit cards to pay for the necessities of life -- food, utility bills, and so forth -- while unemployed, always believing that a new job was just around the corner. One the person finally does find a job, the payments on the credit card debt are so high that they can't make them. For a person in this position, a credit card debt consolidation loan might be a great idea that could get them out of debt while avoiding the effects of bankruptcy on their credit rating.
Unfortunately, most debtors wait until they get to the point where their credit has taken more hits than a punch-drunk boxer before they finally get over their denial and realize that they're in over their heads. At that point, few reputable lenders will even think about giving them a loan. Even the local loan shark will have second thoughts.
That leaves the Shylocks of the banking world, who often promise (but seldom deliver) lower payments, often based on questionable assurances that they can somehow convince your existing creditors to accept less than they're owed. Sometimes they can, but don't count on it. Unless your debts have already been charged off, most banks want to be repaid -- in full.
Lenders willing to grant loans to people in financial distress also tend to charge exorbitant interest rates that result in the debtor paying back even more than they originally owed.
Finally, even if you do manage to line up a sweet re-consolidation deal that actually lowers your monthly payment, that extra breathing room may tempt you to take on additional debt using the credit cards you just paid off, leaving you in even worse shape than you were before. So if you take out a debt consolidation loan, commit to paying it off as quickly as possible, and do not take on any new debt until you do.
One possible exception to the rule that it's very difficult to get a debt consolidation loan once your credit is shot might be if you have an established membership in a credit union. Credit unions tend to look more at the individual than at the numbers. If the circumstances that got you into financial trouble were largely beyond your control (for example, if your job was off-shored and your employer shut down your place of business), and if you basically managed your finances responsibly before that happened, you may well be able to convince a credit union to help you out.
In summary, debt consolidation is worth looking at for some debtors, but probably will not be an available option once your credit is completely shot. Be sure to talk only to reputable lenders (especially credit unions belong to or are eligible to join one), and have an attorney review any paperwork completely before you sign it. Most people who consider debt consolidation should also consider Consumer Credit Counseling (scroll down) as an alternative.
Consumer Credit Counseling Services / DMPs
Consumer credit counseling services are (usually) non-profit organizations primarily funded by banks and other lending institutions. They basically roll up all of your debts into one monthly payment, usually called a Debt Management Plan, or DMP for short. The debtor pays a fixed amount to the credit counseling agency every month, and the agency in turn pays the creditors.
The goal is for the debtor to become debt-free (except for their mortgage, if they own a home) within a given period of time (usually three to five years). Banks and other lenders are asked to reduce or waive interest, and those whose loan terms are less than the length of the DMP are asked to extend their terms to that length. They almost always agree to do so.
The debtor is required to participate in counseling on such topics as using credit wisely, budgeting, and so forth. They also are forbidden to take on any new debt at all during the course of the DMP unless they first obtain permission from the credit counseling agency. These requests usually are denied (with the exception of car loans, which usually are allowed).
If the debtor takes out a loan without securing permission in advance, their DMP will almost certainly be terminated, and the banks will again be free to attempt to collect the debts directly from the debtor.
Consumer credit counseling can be a very good choice for some people. For example, families whose incomes have been reduced because the primary wage-earner was forced to take a lower-paying job may find that a DMP enables them to pay off all their debts on their reduced incomes.
But credit counseling is not a perfect solution, either. Being enrolled in a DMP should not affect your FICO score (at least in theory), but you still won't be able to get new credit without the CCC agency's permission. Also, if you have really big debts, you may not be able to work out a DMP that you can afford. Finally, some consumer credit counseling agencies are scam artists -- many have been shut down or have lost their tax-exempt status -- so choose carefully.
Nonetheless, most consumers should at least consider using a consumer credit counseling agency prior to filing for bankruptcy. In fact, in most cases, you will be required to obtain counseling from an approved credit counseling agency prior to your bankruptcy petition being granted.
The FTC has some good advice about dealing with credit counseling agencies here.
Debt Settlement / Debt Relief Services
There's a lot of confusion about debt settlement, but it's really not that complicated a concept. What it boils down to persuading creditors to accept less money than they're actually owed, in return for full payment of the reduced amount either immediately or spread out over a maximum of four monthly payments. (Longer payment arrangements can sometimes be worked out, but four months is usually the maximum.)
Debt settlement companies charge a percentage of the debt in return for their running interference with the banks for you and trying to negotiate the best settlements. Sometimes the fees can be quite hefty, but in theory are offset by the amounts that you save.
Surprisingly, banks and other creditors are often happy to accept these arrangements, especially if they already have doubts about your ability to pay back the debt. It's the old "bird in the hand is worth two in the bush" sort of reasoning. Other lenders can often be nudged to accept settlements if you can prove that you've retained an attorney and are considering bankruptcy as an option. They'd rather get something than nothing.
The easiest debts to settle are those that already have been charged off and sold to a collection agency. Collection agencies typically pay pennies on the dollar for debt, so they're usually quite willing to consider settlements. Because they paid so little for the debt, they can turn a good profit even if they settle for as little as 40 percent of the total amount owing. Paying them usually will not remove the charge-off from your credit record, however. It depends on the agreement between the creditor and the collection agency.
Debt settlement sounds like a dream come true for people in over their heads who would rather not file for bankruptcy, but it does have its disadvantages. The biggest one is that, when all is said and done, fewer than half of people who enroll in debt settlement programs actually complete them. Most eventually file for bankruptcy, meaning that whatever debts they did manage to settle could have been discharged instead.
One reason for this is that few people have enough cash to pay off even settled debt amounts over a few months. Most debt settlement companies advise debtors to open savings accounts and pay the creditors from those accounts once they've built up some money in them. But that assumes that the creditors are willing to wait. Even if they are, the interest and penalties will keep building up.
In addition, most creditors list settled debts on your credit report as "Settled for less than amount owed," which is slightly better than a charge-off, but much worse than "Paid as Agreed." Every payment you miss until you settle with that creditor will also appear as a ding on your credit report. So even if you settle all your debts within a few years, your credit will still be a mess once you're done.
Also, unless your debt settlement company happens to be a lawyer or law firm, being enrolled in a debt settlement plan does not prevent creditors from harassing you by telephone. We do have a few tricks, however, to help you avoid telephone harassment by debt collectors.
Finally, there's really nothing a debt settlement company does that you can't do yourself. Just call the creditor and ask to speak to someone from their "workout" department. Those are the people who try to "work things out" so the bank gets at least some of its money back, and they typically have the authority to settle. They can also do things like extend a loan over a longer repayment period or reduce (or even waive) the interest. Please note that I said they can, not that they necessarily will. Some banks are happy to help, others will never budge, and most fall somewhere in-between.
Where debt settlement companies have an advantage is that they know the ins and outs better. They know which creditors are likely to settle and which ones aren't. They also spare you from having to deal with the often-unfriendly people at the banks' workout departments. In addition, if the debt settlement company is also a law firm (which usually means that they have one lawyer on staff, who may not even be there most of the time), that carries more weight with lenders; and if that "law firm" is representing you, then the creditors can't call you directly to harass you any more.
In summary, using a debt settlement company may be a good option if you're reasonably sure that you'll have enough money to settle your debts within a relatively short period of time, if you don't feel like dealing with creditors yourself, and if you don't want to file for bankruptcy. But most people who try that route fail and wind up paying more money than they would have paid had they simply filed for bankruptcy.
On the other hand, if you actually complete the program, debt settlement will probably cost you less money than a DMP arranged through a credit counseling service because of the reduction in principal. But a completed DMP will have less of a negative impact on your credit rating because you won't have all those missed payments and "Settled for less than amount owed" dings on your credit report. So in short, there are good and bad aspects to debt settlement.
There are many companies offering debt settlement / debt relief services. Some are pretty good, some are not-so-good, and some are truly horrible. You can read what the Federal Trade Commission has to say about Debt Relief companies here and here.