- Understand how various bankruptcy alternatives work.
- Examine the pluses and minuses of each alternative to filing bankruptcy.
- Compare and contrast the different alternatives to filing bankruptcy, to find the solution that is best for you.
What are the alternatives to filing bankruptcy and how do they compare?
Bankruptcy. The word carries a stigma, to most Americans. Most people agree that bankruptcy is something to be avoided, if at all possible. Bankruptcy is the option of last resort.
Bankruptcy comes with many negatives. It requires you to make a public declaration that you cannot handle your finances on your own. It requires a full disclosure of all your assets and complying with all the requests the bankruptcy court makes for supporting documents.
Bankruptcy damages your credit rating severely. The record of your bankruptcy will remain on your credit report for at least 7 years. The costs for filing for bankruptcy are not insignificant. Also, your level of income may disqualify you for the kind of bankruptcy, called chapter 7, that wipes out all of your debts immediately.
Quick Tip No. 1
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What is Bankruptcy?
When most people think of bankruptcy, they think of chapter 7, which is a fresh start that wipes out their old debts. Due to changes made to the US Bankruptcy Code in 2005, it is much harder to qualify for a Chapter 7 bankruptcy than it used to be. Many people do not qualify for chapter 7 bankruptcy, regardless of the fact that they feel that they are overwhelmed with unsecured debts.
To qualify for a chapter 7 bankruptcy, you have to prove that you have a severe financial hardship, based on your income, some of your living expenses, and your assets. If you earn too much or have some assets worth more than a certain value, then you will not qualify for a chapter 7 bankruptcy.
If you do not qualify for a chapter 7 bankruptcy, the most common kind of bankruptcy you may qualify for is a chapter 13 bankruptcy. A chapter 13 bankruptcy is one where the court establishes a 5-year payment plan for you to repay your creditors.
4 Bankruptcy Alternatives
There are several possible alternatives to bankruptcy for those in financial trouble. It is important that you consider all available alternatives to find the one that best suits your needs. Each approach has pluses and minuses, so it is important to compare them before you make a decision as to how to proceed.
A Consumer Credit Counseling Service (CCCS) is one specific type of debt management plan that is an alternative to filing bankruptcy. In a CCCS program, you make one payment to the CCCS firm and it then distributes payments to your participating creditors. CCCS firms negotiate lower interest rates with your creditors. By obtaining interest rate concessions from your lenders or creditors, more of the payment you make each month goes to the principal balance. This speeds up the time that it takes you to become debt free. Because the main benefit of a CCCS program is lowering your interest rates, it is a better choice for you if you are carrying high-interest debt. CCCS programs are less effective if your interest rates are already low.
In a credit counseling program, you repay 100% of your debts plus interest. Often, in a Consumer Credit Counseling program, the size of the program’s monthly payment is not significantly lower than the current monthly minimum payments you are sending to your creditors. This means that if you are having trouble making your current payment, a CCCS program may not be right for you. The program demands that you make a timely payment each month. If not, you could end dropping out of the program without having resolved your debt problem and delayed resolving the problem because you did not choose the best option for your circumstances in the first place.
A high percentage of people who enroll in CCCS programs drop out before completing the program, which means they end up not solving their debt problems. On average, most credit counseling programs take 5 years. Although most credit counseling programs do not have a negative impact your FICO score, being enrolled in a credit counseling debt management plan does show up on your credit report and affects your credit rating during the time you are enrolled in the program. Unfortunately, many lenders look at enrollment in CCCS program as akin to filing for chapter 13 bankruptcy. In both cases you needed the assistance of an outsider to re-organize your debts.
Debt settlement, also called debt negotiation, is a form of debt consolidation that reduces your total debt. Savings can be as much as 50% and debt settlement programs will significantly reduce your monthly payments. Debt settlement programs are geared for people who have a financial hardship that makes it so they either cannot pay their bills or are about to start falling behind. Debt settlement programs typically take about 3 years to complete.
It is important to keep in mind, however, that during the life of your debt settlement program, you are not paying your creditors. This means that a debt settlement solution of debt consolidation will negatively impact your credit rating. Your credit rating will not be good, at a minimum, for the term of your debt settlement program. However, debt settlement is usually the fastest and cheapest way to debt freedom. Debt settlement offers a low monthly payment, while avoiding chapter 7 bankruptcy.
The debt settlement industry must follow Federal Trade Commission rules that went into effect in October, 2010. These rules were created to protect the consumer. For instance, anyone enrolling in a debt settlement program is not required to pay a service fee to the settlement firm until his or her first account has been settled. This makes settlement an even more attractive option for the consumer. If you are considering debt settlement, make sure that you choose a firm that complies with the FTC rules!
In theory, a debt consolidation loan can be a good alternative to filing bankruptcy. In reality, however, most people considering bankruptcy do not have enough equity to borrow against or good enough credit to access the equity if it exists. If you have a valuable asset, such as equity in a home, it is certainly worthwhile looking into refinancing your mortgage to pay debts and make sure to do so, before you fall behind on any monthly payments.
Another reason that it has become harder to borrow money in the past few years is that lenders have tightened their lending requirements. Even if you were able to qualify for a loan in the past, it may be much harder or impossible to do so now. For instance, lenders are stricter about debt-to-income ratio. You could qualify for a loan, in the past, with a debt-to-income ratio (DTI) as high as 55% (leaving aside the kind of ‘liar loans’ that are no longer available that did not examine a borrower’s true DTI). Now, lenders are not granting loans when the DTI is above 45%.
Quick Tip No. 2
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If you have valuable assets that you can sell, to get back on track with your creditors or clear out your debt, then that is also an option worth looking into. Before you sell any assets, however, check out the tax implications for liquidating the asset and also determine whether or not the bankruptcy court would count that asset against you were you to seek bankruptcy protection.
Most retirement accounts are not assets that you are forced to liquidate to pay off your creditors. That means it could be a very foolish decision to liquidate your 401(k) account, to repay a debt that could otherwise be discharged in bankruptcy. Not only would incur taxes and tax penalties by drawing on your retirement funds earlier than allowed, you could end up paying back a debt that the court would have wiped out. Other assets, such as equity in cars or property are exempt from collection by creditors in a bankruptcy, depending on the laws of your state. Make sure to understand whether a creditor would have claim to the equity in your assets, before you sell or borrow against the assets!
Make sure to look at all your alternatives for getting out of debt, before deciding on any particular course of action, especially bankruptcy, which has the strongest negative effects on your credit rating. Because each consumer is different, do the proper homework to find the debt relief option that best fits your circumstances.
Here are some quick tips, to help you figure out which debt relief option is the one that should be the first one you research in greater depth:
- If you have excellent credit and have equity in your home or in some other valuable asset, then consider a mortgage refinance or selling the asset. Do not liquidate an asset that the bankruptcy court would not force you to liquidate to repay your creditors.
- If you can afford a healthy monthly payment (about 3% of your total debt each month), are not making any progress in paying down your debt due to carrying high-interest debt, you want to protect yourself from aggressive creditor collection actions, and you do not want to go delinquent with your creditors, then consider credit counseling.
- If you are unable to maintain your monthly payments to your creditors or are about to be unable to do so, then look into debt settlement. Debt settlement will offer the lowest monthly payment and allow you to get out of debt in the shortest amount of time and at the lowest overall cost while avoiding bankruptcy. Make sure that you understand and can handle the adverse credit impact and potential collections that come with debt settlement.
- If you cannot afford anything in a monthly payment (less than 1.5% of your total debt each month) — consider bankruptcy to see if chapter 7 might be right for you. If you are thinking about bankruptcy, consult with an experienced bankruptcy attorney.