What is the disadvantage of debt settlement vs. bankruptcy? We all hear about settling taxes and debts on radio and TV instead of filing a Chapter 7 or 13 bankruptcy. But many Debtors find out a year or more later, after paying debt settlement companies, they were scammed and wasted time and money. So how does a Chapter 7 or Chapter 13 bankruptcy compare to a debt settlement?
Debt settlement is not a bargain and will do just about the same damage to your credit scores as bankruptcy if you have a high credit score. If your credit score is low, your FICO typically improves. In bankruptcy, debt is reported after discharge as “account closed.” With debt management debts are reported as delinquent. I do not remember meeting anyone with good debt settlement company experience. In the 30+ years that debt settlement has been around as an industry, I have never met anyone who completed a plan successfully. People complete Chapter 7 cases nearly 100% of the time. They complete Chapter 13 cases about 70% of the time. When Chapter 13 fails, the debtor typically converts to Chapter 7.
Of the 30% of the Chapter 13 cases that “fail,” many are dismissed because the debtor sold or caught up on the home mortgage. The debtor is no longer in foreclosure because he sold the home, got a modification, or cured the default and no longer needs Chapter 13. The other factor is that some debtors become disabled or divorced, making Chapter 13 unaffordable and then converting to Chapter 7. Debt settlement plans fail over 90% of the time. If you are considering debt management, look at doing the pre-requisite credit counseling and filing a Chapter 7 or 13.
Comparing Debt Settlement vs. Bankruptcy
To begin, the debt settlement firms ask you to pay them instead of credit cards. After paying the debt settlement company a significant amount, debt settlement companies attempt to settle these debts. However, Debt Settlement companies have little or no power to force credit card companies to accept any offer. As a result, most debt settlement companies rarely settle for 50% or less.
Conversely, Bankruptcy court judges often issue federal court orders and order debtors to pay creditors 10% or less and ask creditors to accept it. Almost all Chapter 7 cases pay 0%. If I had to estimate the average Chapter 13, I would say it probably repays about 30% to the unsecured creditors depending on the district. Plus, most people complete a Chapter 7 bankruptcy over 99% of the time within four months. People take years and rarely complete debt settlements.
What You are Not Told About Debt Settlement Companies
Debt settlement companies often file bankruptcy themselves taking your money with them. For example, see how Ameridebt took the money and then filed for bankruptcy. The fact is, most people are never able to complete these debt settlement plans and eventually file bankruptcy anyway. An overwhelming number of people who sign up with debt settlement companies eventually file a Chapter 7 or 13 bankruptcy.
Many debt settlement companies file bankruptcy themselves after starting up, and your money is lost. They often advertise themselves as nonprofit or charity agencies. Ameridebt and other “nonprofit” agencies have filed for bankruptcy after paying millions to corporate officers who ran the “charity” and very little or nothing to the debts they were supposed to pay. But almost everything operated to “help” the poor is a scam, including foreclosure rescue, debt relief, and credit repair companies.
Many debt management offices offer to provide the pre-requisite financial counseling for filing bankruptcy. But they bait and switch clients from bankruptcy and then sell them a debt management plan to earn fees. Chapter 7 is far better at discharging personal loans and unsecured debts.
If you cannot complete Chapter 13, you might be able to convert to Chapter 7 or obtain an early discharge. On the other hand, if you don’t complete a debt settlement, you lose the money paid and still owe the debts. You might even end up owing more than your original debt that is the reason why credit counseling is a must. Debt settlement companies do not tell you that you can negotiate directly for credit card debt with credit card companies.
Chapter 13 Has a Much Higher Rate of Success than Debt Settlement Companies
With Chapter 13, you can suspend payment, modify the plan, convert to Chapter 7, lower your payment temporarily or get an early discharge if you can’t complete the plan due to a problem. It is common for a debtor to go through a divorce or become disabled, causing the Chapter 13 or debt settlement plan to fail.
Just like it is customary to reinjure a broken leg, persons in financial trouble often continue to have health, family, or work problems. If you complete most of a Chapter 13 plan and have issues, you may get an early hardship discharge.
Converting to a Chapter 7 or suspending plan payments is an option. But there are no options with debt settlement. You must complete settlement agreements, or you return to owing the total amount. If you need to protect a co-signer or property, Chapter 13 is a good option.
You Can’t Force the Creditors to Accept Lump Sum Payment Through Debt Settlement.
For Debt Management to be effective, the creditors have to accept your offers. Creditors can be forced to take a court-approved (confirmed) Chapter 13 bankruptcy plan or Chapter7. Bankruptcy has the power of a federal judge and court orders to force creditors. These orders can strip a second mortgage or order the lender to release the lien from your car if you pay the car’s value through redemption, whether the bank likes it or not. Only bankruptcy has the power to force a restructure. Some states allow the credit card company to take the debt settlement payment and sue anyway due to a “lack of consideration.”
Chapter 13 Often Repays Less Because You Only Pay Your Disposable Income
Some of our Chapter 13 cases have repaid 0% to the unsecured creditors. You may repay less than 10% to unsecured creditors in Chapter 13. Most debt management or debt settlement plans require at least a 50% repayment, whether you can afford it or not. Over 99% of our Chapter 7 cases repay 0%.
Bankruptcy costs less than debt management and takes less time than debt management. For persons that earn less than the average income, their Chapter 13 plans are often short, 3-year plans. If you want to know if you are likely to lose property, consult an attorney and prepare a Chapter 7 or 13 to see if it is better. If bankruptcy does not offer you an advantage, decide not to file bankruptcy and do debt management, whether for secured debt or unsecured debt.
Debt Management Companies Often Pay Themselves from the First Payments You Make into Their Plan
If the plan fails, the debt management company wants its fees paid from the first dollar you pay into the plan. Nothing may have been paid on your home or auto claim when it fails. These fees are generally non-refundable and are spent before they do any work. If the debt settlement plan fails within the first year, the debt settlement firm is often the only person that gets paid. I get paid my attorney fees upfront in Chapter 7, too. However, my office runs a 99% success rate at getting Chapter 7 cases discharged. Debt Settlement has over a 90% failure rate estimated in the high 90s by NACBA.
Banks Own Many of the Debt Settlement Companies
Some lenders like Bank of America will only accept your debt settlement if you use a debt management service they approve or own. Check how long a debt settlement company has been licensed in your state. If they aren’t approved by the Secretary of State as a corporation for at least five years, don’t do business with them. Often the company that claims it is 15 years old just started last month or is not even licensed.
The Person Managing your Debt Management Plan Often has No Training or Education.
Many attorneys in the bankruptcy area are CPAs, certified financial planners, or have training in tax and accounting. I managed an accounting division of an oil company, sat for the CPA exam, and was a tax prosecutor in charge of state tax auditors. Often, a debt settlement employee only has the training to sell you on debt settlement. He has little or no legal or financial training and experience.
If you feel you must morally repay your debts, consider a Chapter 13 instead of using debt settlement. Often, the work of “debt management experts” cannot be verified. Bankruptcy is a more workable solution that you are far more likely to complete than debt settlement.
Damage to Your Credit Rating is Less with Bankruptcy
The damage to a credit rating is about the same or less with bankruptcy debt settlement. You can learn about credit scores and credit reports in credit counseling courses. Either way, debts remain repaid. At the end of a bankruptcy, creditors report the debt as an account closed. That language makes it sound more like it was paid.
Debt settlement reports the account typically as being charged off or unpaid. If you do not pay debts on time, your credit report suffers whether you repay through debt management or a Chapter 13. In either situation (Bankruptcy or settlement), you will need to sweep your credit report file afterward.
Some Debt Settlement Companies are Often Frauds
In one fraudulent scheme, a debt settlement company instructed a debtor to transfer all of his legal property to them to avoid the claims of creditors. They claimed that these legal documents would keep creditors from successfully suing him. Then, they sold his assets.
Debt Settlement vs. Bankruptcy and Taxable Income
In debt settlement, any debt settled is treated by the IRS as income for tax purposes. The lender issues a 1099-c for earned income. That means if a credit card company forgives $30,000 worth of your debt, you pay income taxes on $30,000 as if you earned $30,000. Conversely, bankruptcy does not treat discharging the debt as income. If a creditor issues a 1099-C, the tax code exempts debts discharged in a bankruptcy from income taxation.
Debt settlement offers minimal benefit because of this tax problem. But a Chapter 7 or 13 bankruptcy eliminates debt with no tax consequences. Banks turn in 1099 to the IRS for the amount “forgiven.” If a bank agrees to charge off $100,000, you will repay about $40,000 in taxes for the $100,000 of debt forgiveness, just as if you earned the $100,000 in ordinary income.
Ask H&R Block or any tax professional. The only guaranteed method to avoid taxation from a short sale, debt charge off, foreclosure, or debt settlement from 1099 is to file bankruptcy. Even if the mortgage company agrees to debt relief as a settled debt, they will issue 1099 for the loss to get the tax advantage and comply with accounting and IRS rules. The IRS will then issue an assessment. Real estate agents want the short sale income. They may forget to explain this tax problem.
Do You Still Have Confusion about Whether Debt Settlement or Bankruptcy?
If you still have questions and second thoughts about whether you should think about debt settlement or bankruptcy, there is nothing better than contacting an experienced bankruptcy attorney to guide you better.
Nick has been dealing with bankruptcy cases for over 30 years now and understands the essential points to consider and how to get you debt relief. Contact my law firm now to guide and help yourself or other people infiling. We build a trusted attorney-client relationship to help you in the best way from our expertise.
Resources for Bankruptcy
An attorney/CPA is far more qualified and often costs less than someone great at closing sales for debt management plans over the phone. The foreclosure rescue company or debt settlement salesperson may make you feel good, but it will often cost you more and not allow you to keep your home due to the high failure rate. If you are considering filing bankruptcy, don’t delay because timing is crucial. I am here to help you. So, contact my office immediately to start the conversation—Nick C. Thompson, Bankruptcy Lawyer: 502-625-0905.