What’s the difference between a debt consolidation program and bankruptcy?
Many people think that debt consolidation is a good way to avoid bankruptcy. But for many reasons, debt consolidation programs can be a bigger headache than most people realize. We’ll break down the difference between debt consolidation programs and filing for bankruptcy and let you be the judge.
How Debt Consolidation Works
Here’s how many debt settlement companies work: They tell you to stop paying your credit card bills each month, and instead, send a payment to the debt settlement company.
The company should escrow the money (hold it in an account). They allow the debt to become delinquent. Then, when the debt is extremely overdue, the debt settlement company offers the credit card company a lump sum (in a smaller amount that is owed) to write off the debt.
How Does Debt Consolidation Impact Your Credit Score?
People may think that debt settlement won’t affect their credit negatively. However, this is rarely true. As we just explained, the debt settlement company will hold back your payments, which means the credit card companies will report your delinquency to the credit bureaus, which will pull down your credit score.
Additionally, the balances may be reported as “written off” on your credit report – but they won’t disappear completely. It is true that bankruptcy can also pull down your credit score, but filing bankruptcy can essentially establish a baseline from which you can rebuild your credit.
All the negative things reporting to your credit report should stop so that you can get to work rebuilding your score when your bankruptcy is discharged.
Debt Collections and Lawsuits
When you’re in a debt settlement program, the collection activity does not have to stop. You’ll still be subject to collection calls, bills in the mail, and potentially a lawsuit for the delinquent balance. On the other hand, once a bankruptcy is filed, all collections must stop.
Your creditors cannot call you, send you bills, or sue you. If they collect from you, they are in violation of the “Automatic Stay” of bankruptcy. They could be sued for that.
The Tax Consequences of Debt Consolidation
Perhaps the biggest surprise you will encounter if you are able to successfully negotiate a settlement with a debt collector or creditor is good old Uncle Sam.
The IRS taxes you on any debt that is forgiven. If you owed $5,000, but are able to settle it for $3,000, you will be taxed on the $2,000 that was forgiven. In addition, the tax on the $2,000 cannot be discharged or wiped out in bankruptcy. Whereas, if you file bankruptcy, you are not taxed on the debt you wipe out with bankruptcy.
With Debt Consolidation, There’s No Guarantee
After all this time and effort, and after you have missed several payments in order to get into a position to settle your debt, the credit card company could refuse to settle the debt. They could then sue you for the balance.
In this scenario, you would end up owing more than you did in the first place. The delinquent credit card balance would now include interest, late fees, and attorney fees.
Compare that scenario to bankruptcy: your creditors do not have an option whether or not they are part of your bankruptcy case. If you file a Chapter 7 or Chapter 13 and list a credit card company, and your case is successfully discharged, that credit card company cannot collect from you ever again.
Additionally, an Automatic Stay would be put in place upon filing, and they would be forced to stop contacting you immediately.
Who Can You Trust?
If you decide to use a debt settlement program, be sure to research the company thoroughly before entrusting them with your money. In June 2017, the FTC (Federal Trade Commission) shut down 11 debt settlement companies for taking people’s money but failing to pay their creditors.
Note that if you are discharging your debts in a Chapter 7 bankruptcy, or repaying your debts in a Chapter 13 bankruptcy, the entire process is regulated by the U.S. Bankruptcy Court.
You can trust the bankruptcy process knowing that there are laws on your side to protect you, the consumer, from collection efforts by your creditors.