Update: In November of 2017 the Consumer Federal Protection Bureau sued the largest Debt Settlement company: Freedom Debt Relief. Read about that here
Lots of my clients come to me after having tried some type of credit counseling program. The reaction is always the same — “I should have come to you first.” The purpose of this post is to give you a sense of how credit counseling works and how a Bankruptcy works. Hopefully this allows you to make an educated choice on what truly is the best way to move forward with your financial issues.
Debt Relief Companies
The basics model of a debt relief company is:
- You make monthly payments to the company.
- The company uses this monthly payments to build up a “slush fund.”
- This slush fund “settles” your accounts for less than full balance owed.
This seems great because you are paying less than what you actually owe the creditors (hey you are saving money right). But here are the cons to going about it this way:
- It is very expensive to do this. Most companies charge at least 20% of the savings. Thus if they save you $20,000 then you are paying them at least $4,000.
- You are taxed on the savings. So if they “save” you $20,000 then you will get a 1099c from the creditors meaning you pay taxes on that $20,000 next year.
- Your credit still goes down dramatically. You aren’t making payments to the creditors so your score will still go down.
- Collection activity still happens. You still get letters, phones calls, and can still be sued from creditors while in the program.
- It takes a long time to complete.
- You’re dealing with a big bureaucratic organization.
Bankruptcy is federal law. This means a couple of different things: 1) generally everyone is eligible for relief under the US Bankruptcy code via either a Chapter 7 Bankruptcy or Chapter 13 Bankruptcy; and 2) All creditors are required to operate under the umbrella of Bankruptcy and have no choice but accept the relief you are asking for (either within a 7 or a 13).
When dealing with unsecured debt, Bankruptcy looks at your income and and determines (based the income amount and your household size) how much, if anything, you can afford to pay back to your unsecured creditors. If the formula determines you can’t afford to pay anything back then you are eligible for Chapter 7 Bankruptcy. If you are not eligible for Chapter 7 then this same formula determines how much you are required to pay back to your unsecured creditors in a Chapter 13 Plan (most people pay back a percentage of what they owe in a Chapter 13).
Here are a few simplified benefits of Bankruptcy vs. Credit Counseling:
- The fees are a lot less. Most Chapter 7 cases can get done for around $2,000 and a Chapter 13 case is generally around $3500.
- There are no taxes paid on debts discharged in Bankruptcy.
- It is easier to gain/rebuild credit after a Bankruptcy discharge (a discharge is a Federal Court Order which means new creditors can see it know that you legally do not owe anyone else). If they know you don’t owe anybody else then they aren’t competing for your dollars and are more likely to give you new credit to rebuild. Read more about typical results for this here
- Collection activity is required to stop. Bankruptcy has a federal injunction that prevents collection activity once you file (no phone calls, letters, and even lawsuits have to stop).
- It can be extremely fast (Chapter 7 takes about 3 months).
- You are dealing with an attorney (we have a legal and ethical obligation to do our best for you, answer questions, and finish the job you hired us to do).
Once you’ve made the decision that you need to do something about your debt then do your research. I’m not saying Bankruptcy is always the answer. However, don’t ignore it just because you think it is a dirty word. There is a reason why a lot of people try other things and then end up in my office. Remember, Bankruptcy is federal law that was enacted for the general protection of the public.