Choosing between Bankruptcy, Credit Counseling Debt Consolidation and Debt Negotiation

The Internet has been bombarded by endless debt management misinformation. However, to help you make an informed financial decision, this article clears some of the confusion between bankruptcy, credit counseling, debt consolidation, and debt negotiation:

Bankruptcy

For a troubled debtor, the easiest solution is to throw in the towel and declare bankruptcy. But, bankruptcy critics suggest that most bankruptcies could have been avoided if the filers had an additional $250 in monthly income. This observation suggests that many Americans decide to file bankruptcy prematurely.

Filing bankruptcy today is not as attractive as it was. A new bankruptcy law, the Bankruptcy Abuse Prevention and Consumer Protection Act, made it more difficult for filers to qualify for Chapter 7, also known as "straight bankruptcy." Chapter 7 was always the preferred bankruptcy method Americans and is the most-feared bankruptcy of any creditor since it allows a bankruptcy filer to gain a fresh start by discharging most debts.

The new law also inconveniently requires bankruptcy filers to pass a complex "means test." The means test determines people's eligibility for debt relief depending on their financial means to pay a portion of their debts. Many filers, whose income was calculated above the median income in their state, have failed the means test. Their only option was to file for Chapter 13.

Also referred to as the "wage earner's plan", Chapter 13 places a bankruptcy filer at the mercy of a bankruptcy court, which ultimately decides what portion of the debt the debtor must pay. The law also extended the Chapter 13 court-ordered debt repayment plan from 3 to 5 years, thereby prolonging the period to get out of debt. Another major problem is that over 60 percent of all Chapter 13 bankruptcy cases are dismissed by bankruptcy courts. A Chapter 13 bankruptcy case gets thrown out of court if the bankruptcy filer misses one court-ordered payment.

Finally, bankruptcy causes the longest-term credit damage. The negative mark remains 10 years on a consumer's credit file. This means that for many years, the stigma of a bankruptcy on your consumer's credit report can make it difficult for you to qualify for credit or employment. Because this makes you a high credit risk, you should also be prepared to pay the highest interest rates and fees.

Before a bankruptcy can be discharged, consumers are also now required to receive consumer credit counseling from an organization approved by the bankruptcy trustee within six months of the date of filing a bankruptcy case. The objective of introducing the credit counseling prerequisite is essentially to dissuade a person from filing bankruptcy. In lieu of a bankruptcy, a credit counselor would offer the potential bankruptcy filer enrollment in a debt management plan. However, as we're about to discuss, this alternative is often futile.

Credit Counseling

Credit counseling, a.k.a., consumer credit counseling is the most commonly pursued debt management option in the United States. It is a debt consolidation procedure primarily used by debtors to eliminate credit card debt. Following this approach, a credit counselor will give debt counseling advice to a consumer that lives paycheck to paycheck and consequently struggles to make, or cannot make the unbearable minimum payments. The credit counselor also assists the debtor by enrolling the debtor in a debt management plan (DMP).

The goal of the debt management plan is to set up for the debtor a debt repayment agreement with your creditors, which reduces the interest rates of the enrolled credit card accounts, or other eligible unsecured debts. The debt management plan is based on the given interest rate reduction term set by each creditor. The debtor is required to make a consolidated monthly payment to the debt management plan, which in turn, pays each creditor.

Although in theory, credit counseling sounds like a magnificent debt reduction concept, according to a Consumer Reports survey, the debt elimination practice has experienced a 21 percent completion rate. A leading cause for the high dropout rate is that debt management plans set up debt repayment plans that often exceed the consumers' former minimum payments to creditors. A secondary factor is that the primary benefit of credit counseling is providing the debtor interest rate reduction, which generally barely dents a high debt load.

People should be aware that any debt management decision - including credit counseling - will hurt their credit. A major consumer complaint is that the timeframe taken by a debt management plan to establish a creditor payment agreement caused "late payments" to be reported on the consumer's credit report. Late payments have also been reported when payments due to creditors weren't made on time. Moreover, enrollment in a debt management plan causes creditors to report to credit bureaus that the debtor is enrolled in a "Debt Management Hardship Plan." This mark on a credit report does not affect consumers' credit scores. However, it warns lenders that the consumers were "unfit" to manage their debts."

Debt Consolidation

Frequently confused with a debt management plan, "debt consolidation" is the process of acquiring a low-interest loan, typically a home equity loan, to consolidate one or more high-interest debts. In turn, the financially challenged borrower can benefit from a lower monthly payment. However, the downside to a debt consolidation loan is the tradeoff of unsecured debt for secured debt.

In exchange for the debt consolidation loan, the borrower must own property, which would serve as collateral for the loan. Additionally, the borrower must pledge the equity on the borrower's property as a guarantee for repayment of the loan. However, this is a very dangerous practice, which places the borrower at the risk of losing his property. If the borrower defaults on the loan due to a financial hardship, the mortgage lender will be able to begin foreclosure on the borrower's home to recoup the outstanding loan balance.

Debt Negotiation

Debt negotiation is most suitable for a debtor with a severe financial hardship, who won't consider bankruptcy as an option. This effective bankruptcy alternative can provide far better debt reduction than credit counseling. But, like any debt management option, debt negotiation, a.k.a. "debt settlement", has its pros and cons.

In the debt negotiation practice, a debtor will hire a professional debt negotiator to negotiate with creditors a mutually agreeable settlement of the debtor's unpaid debts. The established debt payoff can produce a sizeable reduction of the negotiated debts. In turn, the debtor can experience a respectable savings on the outstanding debt balance, including principal, interest, and fees.

A downside of debt negotiation is that unlike a credit counseling debt management plan, the debtor isn't paying creditors each month. Instead, the debtor is disciplined in saving up funds each month to buildup the lump sums required to settle each debt.

Critics have assailed the debt elimination solution because it damages a consumer's credit. The negotiation process likely leads to late payments and charge offs reported on the consumer's credit file. However, these derogatory credit items do not remain on a consumer's credit file as long as a bankruptcy. With time, a consumer's credit score can improve. Plus, the resulting debt payoff also lowers the debt-to-credit ratio, a credit category, which composes one third of the consumer credit score.

Another negative aspect of debt settlement is the possibility of a creditor lawsuit. However, by enlisting the services of a trained negotiator, it is possible to negotiate an out-of-court settlement of a legal demand.

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