Bankruptcy versus Credit Counseling

Debt Consolidation Services

A Possible Alternative

A good credit counseling service will focus on your personal financial situation. This includes common sense steps such as establishing a sensible budget. Next, they will attempt to renegotiate your debts by negotiating lower interest rates or getting reductions in your principle balance. The consumer who uses this service traditionally pays monthly lump sum to the service which covers both the payment on the client’s debt, and the counseling services fees. Some companies do not collect the counseling fee from the consumer because they receive funding from credit card companies. What is important to note is that all of these services can be done without the help of the credit counseling service. You have the power to make a budget, contact your creditors, and negotiate interest rates and other terms.

Credit counseling services claim that a major benefit of using their services versus Bankruptcy is the effect on your credit score. For the truth about the effect on your credit score and your ability to gain credit click here.

Be Aware of Debt Consolidation Loans and Predatory Services

Many debt services are predatory in nature, taking advantage of consumers overloaded by debt. Be aware of any service that is really a loan or any service that offers to fix the problem without providing any counseling services such as budgeting. The typical predatory service will offer to negotiate down your debts. They will claim that their “fee” is at no direct cost to you because it will only come from the money that they are saving you. However, these plans typically have front loaded fees. This means that the fees fund an account to negotiate a settlement further down the road. Thus, during this time they are not making monthly payments to your creditors. In the event that you are unable to continue payment, they keep all your money without a penny going to your creditors.The Federal Trade Commission has recently written about this subject and offers tips for those thinking about using a debt consolidation services.

• Example 1 – Charlie credit card holder has total credit card debts of $30,000 and feels overwhelmed. He signs up with a debt consolidator who claims he can negotiate that amount down to $10,000. Charlie likes the sound of that and agrees to give $333 every month to the debt consolidator for 36 months. The $333 per month for 36 months actually totals $12,000 representing a $2,000 profit for the debt consolidator. In month 18, Charlie’s car breaks down and he had to pay to get it fixed in order to go to work. Because of this he was unable to make his payment to the debt consolidator. When this happened the debt consolidator kept all the previous payments and his credit card company received nothing. Charlie has now wasted any payments he has made to the debt consolidator, has further harmed his credit, and still owes the credit card companies money.

Advantages of Bankruptcy over Debt Consolidators

An Attorney is Working For You

The debt consolidation industry was started and is still paid for by the credit card industry. Thus, the debt consolidation system is designed to work in the credit card company’s best interest. To contrast, a Bankruptcy attorney is obligated by state law to work in your best interest. If he does not he faces disciplinary action including disbarment. A former Texas Assistant Attorney General described the situation well:

• “I think that consumer credit counseling service is intrinsically deceptive.  They're funded or incorporated by the very people they are truly representing… not the consumer/debtor but the creditors trying to collect the money.  I think they're a con; they pitch themselves as serving the consumer's best interest but they don't.  Their promotions practices are deceptive and the consumers are being grossly misled.  If they were lawyers, they'd get disbarred!  Representing one-party and acting for the other?  Come on!  Think about it!  If lawyers won't get involved in an enterprise like Consumer Credit Counseling, you know it must be bad.”

Creditors Have to Comply with a Bankruptcy Judge

The Bankruptcy laws give the consumer certain requirements for filing Chapter 13 Bankruptcy. When these requirements are met, the plan must be confirmed. This confirmation, approved by a United States Bankruptcy Judge, is mandatory on all creditors. To contrast, creditors are not obligated to comply with or even talk with debt consolidation services.

Bankruptcy Provides the Protection of an Automatic Stay

The filing of a Chapter 13 Bankruptcy initiates the protection of the automatic stay. The automatic stay is a Bankruptcy court injunction that is like a stop sign, preventing almost all collection activity that creditors use against you. Specifically, this automatic stay has the power to stop creditor harassment, foreclosures, repossessions, and garnishments.

Debt consolidation services can negotiate to end creditor calls or other measures. However, there is no obligation for the credit card company to agree. Additionally, the credit card company is not required to even talk to debt consolidators and may use the contact as incentive to file a lawsuit against the consumer in an attempt to get a head start on other creditors by obtaining a judgment in court against the consumer. The filing of a Bankruptcy petition stops all of these things from happening. The creditor must be a part of the Bankruptcy process if they wish to be paid and must stop all collection activities during the length of the automatic stay.

Includes Most Debts Including Mortgages and Car Loans

Debt consolidation companies are subsidized and created for the benefit of credit card companies. Therefore, they will typically only deal with credit card debt. However, many consumers who find themselves behind need help with debt secured by collateral such as their home mortgage and car loan(s). Bankruptcy allows the consumer to pay arrears (past due payments) and penalties on these loans secured by collateral over the term of the plan. Additionally, the plan has the potential to significantly lower payments on loans such as car notes.

No Interest or Late Fees

The Chapter 13 petition typically stops any late fees or penalties from accruing on the balance of your debt. Additionally, the amount will usually be repaid without the accumulating interest.

Bankruptcy Pays Your Most Important Bills First

A Chapter 13 bankruptcy plan pays off most secured loans first and delays payment of unsecured debts. Initially, the majority of the Chapter 13 plan’s payments will go toward repaying any mortgage and automobile payment defaults. Credit cards and medical bills can be paid after these secured and other priority claims have been paid off. Debt consolidation companies normally do not have give preferential payment to your home and car lenders.

How Does Bankruptcy Affect Your Credit Score

Your credit score is a reflection of all the credit related activities that you have done up to this point. Because of this, if you are considering relief under Bankruptcy, your credit score has likely already been affected enough to prevent you from getting favorable interest rates or any additional credit. Debt consolidation or credit counseling services often claim that their service is better because Bankruptcy shows up on your credit report for ten years, thus limiting your ability to gain credit after you file. This statement is only partially true.

The Truth

Your Credit Score Is Only One Element in the Ability to Gain New Credit

Interest rates and the ability to get credit are based on the risk that you give to the creditor. The more risk the more likely to get higher interest rates or to get no credit. Credit companies generally rate your risk on three different factors: (1) your credit; (2) your collateral; and (3) your character.

• Your Credit – your credit is generally broken down into two factors: (1) your “FICO” score; and (2) your debt to income ratio. Your "FICO" or credit score is complex and based on many different factors. However, it can be simplified and explained as your past payment history and your current use of credit. To contrast your debt to income ratio calculates how much of your income every month is going toward paying your debts. This figure includes amounts paid for car payments, home mortgages, and any credit card debt.

• Filing for Bankruptcy negatively affects your payment history. However, this part of your score has likely already been damaged from things such as paying late or paying less than the minimum. To contrast, Bankruptcy can positively affect your debt to income ratio. This is due to the fact that debts are either discharged in a Chapter 7 plan or reduced in a Chapter 13 plan.

• Your Character – evaluating your character is similar to evaluating your stability. Creditors evaluate your stability by looking at such things as: (1) whether your rent or own your home; (2) how long you have been at a given address; (3) how long you have been employed with your employer; and (4) whether you have checking and savings account.

The Bottom Line

Contrary to what some will tell you, Bankruptcy does not mean the end of getting credit. Rather, it can actually help someone gain new credit because past debts are discharged, and the new creditor knows that you cannot file for Bankruptcy again for an extended period of time of 7 to 10 years.

Generally, you should not decide whether or not to file Bankruptcy based on the affect on your credit score. This is true because most of the time your credit score is already bad enough to prevent you from gaining new credit. Additionally, most of the time saving the few points on your credit score is not worth the extra expense involved in paying higher interest rates on items such as your credit cards and car loans.