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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.

 

Paying Down Your Debt

This option isn't for everyone. If you're already in over your head and can't even make minimum payments, then you're past the point where paying off your debt without assistance is a viable option. But if you're still able to make minimum payments and have a little bit left over, read on.

One mistake that people in deep debt make is trying to "be fair" to creditors by divvying up what money they have between them. For example, if they have 10 payments and can afford, with difficulty, to pay $200.00 a month over the sum total of the minimum payments, they'll pay each creditor $20.00 more than the minimum payment. And if they stop using the credit lines and continuing divvying up the money like that, eventually the debts will get paid off. So if you're comfortable with that approach, more power to you.

There's another approach, however, that many people find to be a faster, more satisfying way to approach the problem, and that is to pay off the smallest balances first. This works best if you have multiple credit cards or other debts with small balances. By completely paying off those small debts, you will reduce your total monthly payments and increase the amounts you can pay against the bigger balances every month. You'll also give yourself a bit of breathing room in terms of disposable cash every month.

The way you do this is by making only minimum payments plus some token amount to everyone except the creditor with the smallest balance until that account is completely paid off. Then you move on to the next smallest balance, and then the next one after that, working your way up the ladder of your debt. What you'll find is that as you eliminate the payments for those smaller debts, you'll have more available cash to start paying off the bigger ones.

There are two caveats to this approach. The first is that you have to avoid getting any deeper in debt, ideally by not using your credit cards or credit lines any more. If you simply must charge some purchases against plastic (for example, for online purchases, automated highway toll collection, or other scenarios in which cash isn't an option), then either use a debit card or use one credit card, always being sure to pay at least the minimum payment plus the total of any additional purchases you made that month. So if the minimum payment is $100.00, and you made $125.00 in purchases, pay at least $225.00 when the bill arrives for that one selected card. You don't want to get any deeper in debt than you already are. So if possible, avoid using credit cards altogether; and if you must use credit, then select one card and always avoid getting any deeper in debt on that card by paying the minimum payment plus the amount of any new purchases every month.

The second caveat is that you should always pay everyone other than the card with the lowest balance (and the one card you're still using, if that applies) slightly more than the minimum payment. The reason is that in most cases, the minimum payment will barely cover the interest. Whatever you may over the minimum usually will go toward principal. So pick an amount over the minimum and add it on to the minimum when you make the payment. Maybe it will be a dollar, maybe it will be 10 percent of the minimum payment, or maybe it will be the minimum payment rounded up to the next $5.00 or $10.00 increment. Whatever you choose, pay everyone slightly over the minimum except for the creditor with the smallest balance (and the creditor whose card you're still using, if that applies).

The bulk of your available cash, however, will go to the creditor whose card or loan has the lowest balance, until that card is completely paid off. Then start working on the card with the next-smallest balance and work your way up the ladder. Every debt you pay off will result in more available cash to pay off more debt.

 

Pawn Shops, Auctions, and Classified Sales

If you have stamps, coins, collectibles, firearms, tools, equipment, or other unneeded items that are worth some money, you may want to consider selling them and using all of the proceeds to pay down your debt. The money you save on debt service may very well exceed whatever you were hoping to earn from the appreciation of an asset's sale value.

Pawn shops are often the fastest way to convert unneeded items to cash, but they also pay the least. Figure on 40 to 50 percent of the item's retail value at best -- and even then, only after the customary haggling. The pawnbroker's initial offer will likely be less than what they're actually willing to pay. Also, tell the pawnbroker that you want to sell the item outright, not take a loan against it. Taking an item as collateral against a loan is more work and results in more costs for the pawnbroker, so they'll usually pay more for outright purchases.

Pawnbrokers also make loans, of course; and if you're sure that a pawn shop loan will get you through a rough time and that you'll be able to pay off the loan when it's due, it may be something to consider. Pawn shop loans are easy to get, but it's the rare pawnbroker who will lend you more then 20 to 25 percent of an item's retail value. If the item is very large or will be hard to sell because of a limited market for it, the amount may be even less. And, of course, if you don't pay, they will sell the item. That's how pawning stuff works. Still, if you're absolutely certain that a pawnshop loan will get you through a crisis and that you can pay it off on time, pawn shop loans can be a quick and easy way to borrow some cash.

Auctions tend to result in better money than a pawnbroker will be willing to give you for an item, but there are costs involved. Traditional auction houses charge hefty fees on the items that they sell, but they also tend to know how to properly price and sell an item. Online auctions like eBay are less expensive, but you'll have to do that research on your own. Make sure to set a minimum or floor bid if there's a minimum amount that you're willing to accept for an item, and don't forget to factor in shipping or delivery costs.

Traditional or online classified ads such as those offered by Craigslist and eBay are also good ways to sell stuff you no longer need. If you set reasonable prices, describe your items honestly and accurately, and include pictures, your stuff will probably sell quickly. I've sold stuff such as used cell phones, snow tires for cars I no longer owned, lawn mowers, pet supplies, furniture, and automobiles on Craigslist, and never once had an item listed for more than a few days before it sold. The keys are to be honest and accurate in your listings, set reasonable prices, and include good pictures.

There are some risks to doing business with strangers, however, including scams, counterfeit cash, and even outright robbery or assault. Craigslist has some good advice to help you avoid scams and sell your stuff safely. Perhaps the most important advice is not to meet potential buyers in sketchy locations. Some good places to conduct business with strangers might be across the street from a police station or in the parking lot of a busy shopping mall. Some bad places would include dark alleys in high-crime neighborhoods. In other words, use some common sense when agreeing to meet strangers.

For used power equipment such as lawn mowers and chain saws, shops that repair and sell those items may be good ways to convert them into cash. Figure on getting about half the price at which they expect to sell the item less whatever it will cost them to repair it and make it saleable.

 

Debt Consolidation

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 high-paying job 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 that 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. Even the few lenders who are willing to grant loans to people in financial distress tend to charge exorbitant interest rates that may result in higher payments than they were paying before. So read any contracts or notes carefully before accepting their terms.

Finally, even if you do manage to line up a sweet debt-consolidation deal that actually lowers your monthly payments, 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. If you don't trust yourself not to use the credit cards, then shred them.

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.

 

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