Master Guide to Debt Consolidation – The Pros and Cons of Debt Resolution Options
Chapter 13 Bankruptcy, Debt Management Programs and Credit Card Debt Consolidation Loans and other Personal/Consolidation Loans
Finding the right option to resolve your debt can be daunting. There is so much information (and in some cases misinformation) in the public regarding various ways to consolidate your debts. It can be hard to decipher what is best for your unique set of circumstances.
It is best to evaluate and understand ALL of your available options before making a decision. This article will breakdown the four main types of debt resolution options and compare based on the following categories/themes:
- Legal Protection from Creditors;
- Debt Reduction, Resolution Tools and Terms;
- Tax Consequences;
- Impact on Credit
All four of the options listed below have the same premise: take multiple smaller payments (each with their own due date, interest rate and terms) and roll them into a single monthly payment with more favorable and singular terms. The goal: debt reduction and less stress and headaches trying to pay bills each month. While this goal is the same across all options, the methods and results vary significantly. Read below to determine which option might be best for your unique circumstances.
CHAPTER 13 BANKRUPTCY
Pros: The plan provides broad legal protection from creditors during the repayment process (i.e. protection from home foreclosure, vehicle repossession and garnishments). The plan provides repayment options and court protection for secured creditors (e.g., mortgage and vehicle financing), priority creditors (e.g., income taxes), and unsecured creditors (medical bills, credit cards, loans). It is the only option discussed that provides court oversight of the debt reduction and legal discharge/elimination of unpaid principal debt. As a result, Chapter 13 offers more certainty than other options that rely mainly on the cooperation and discretion of the creditors.
Cons: While in the Chapter 13 plan, you can only acquire up to $2,000 in new credit without first seeking court approval. The Chapter 13 plan may require you to remit your federal income tax refunds to the bankruptcy Trustee. The Trustee charges a fee to administer the Chapter 13 plan (however, this fee generally is paid from the creditor pool and thus reduces the recovery for creditors vs. adding to the individual’s cost). Many people are concerned with the stigma of filing for bankruptcy.
Chapter 13 bankruptcy simply put is a court authorized debt consolidation program. While Chapter 7 bankruptcy is used to eliminate unsecured debt obligations (such as credit cards, medical bills, personal loans, etc.), the Chapter 13 plan is intended to set up structured repayment terms with each of your creditors. The Chapter 13 is a customized repayment plan tailored to each person’s individual circumstances and budget. The plan runs 36 – 60 months before it completes with a court discharge. This discharge legally eliminates any unpaid balances on unsecured debt obligations, such as credit card, medical bills, personal loans, etc.
Chapter 13 bankruptcy offers many debt resolution tools over a Chapter 7, mainly in area of restructuring debt with secured creditors and providing court protection from creditor actions such as home foreclosure, vehicle repossession, garnishments, etc.
The purpose of the plan is to create a balanced budget. We propose the budget plan and it is approved by the court. Creditors are paid based on the following hierarchy:
- Secured Debts: Such as primary mortgage, vehicle payments, etc.
- Priority Debt: Current income tax liabilities
- Monthly living expenses: Food, gas, insurance, home maintenance, etc.
- Unsecured debts: Such as credit cards, medical bills, second mortgage or home equity loan, personal loans, loan deficiency debt, judgments or wage garnishments. This group of creditors only receives whatever funds are left over after all above expenses have been met. Your unsecured creditors may only receive pennies on the dollar and whatever balances remain at the completion of the program are legally eliminated through a court discharge.
- Legal protection from Creditors: By filing for Chapter 13 bankruptcy, you put an immediate end to creditor actions such as:
- Home foreclosure;
- Vehicle repossession;
- Judgment or wage garnishment;
- Utility Shut-offs;
- Creditor phone calls and harassment.
Timing is important for certain creditor actions, such as home foreclosure. The Chapter 13 bankruptcy must be filed PRIOR to the foreclosure sale in order to legally prevent the sale. In the case of vehicle repossession, the Chapter 13 bankruptcy must be filed prior to the vehicle being sold at auction.
- Debt Reduction, Resolution Tools and Terms: Chapter 13 not only provides broad legal coverage from creditor actions, but it also offers powerful debt reduction options. Under a Chapter 13 bankruptcy we can:
- Structure 0% interest repayment to unsecured creditors.
- Modify secured loans;
- Reduce repayment on unsecured debts based on budget;
- Create repayment terms for student loan debt and IRS tax debts.
The Chapter 13 plan allows you to modify your vehicle loan. If you are paying a high interest rate, it can be reduced under the Chapter 13 plan to a more reasonable rate. If you have owned the vehicle for over 2.5 years, you can reduce what you owe on the vehicle to the fair market value (i.e., Kelly Blue Book) versus the balance of the contract. This is called a “cram down.”
If you would like to pursue a mortgage loan modification, you can pursue that while the Chapter 13 plan is pending with additional access to your mortgage company’s attorney representatives and court oversight to ensure accountability.
One of the most beneficial aspects of the Chapter 13 is the ability to reduce and legally discharge a portion, if not the majority, of your unsecured debt obligations. This includes credit cards balances, medical bills, old utility bills, personal loan, loan deficiency debt, etc. You are only required to pay back what you can afford based on your income, expenses and budget. Whatever is not paid through the course of the Chapter 13 program is then legally eliminated or discharged at the completion of the plan.
The program offers many avenues to reduce debt and eliminate a portion of debt based on individual circumstances (income, monthly living expenses, outstanding debt, etc.):
- Second Mortgage(s) and/or Home Equity Loans can be legally removed from the property if the value is no longer there to support the lien. It becomes an unsecured debt and is paid back at 0% interest and whatever balance remains at the completion of the program is legally eliminated with a court discharge.
- Rental Property(s) can be “crammed down” through the Chapter 13 process. This reduces the principal mortgage balance for the property to current market value. Based on the tenant’s rent, the property will be paid off at the completion of the 36 – 60 repayment process.
- Vehicle Loan(s) can be reduced by:
- Lowering the interest rate
- Extending the terms of the loan.
- If the vehicle has been financed for over 2.5 years, we can reduce the vehicle loan to the current market value of the vehicle instead of the current balance of the car note.
- Unsecured debts can be paid back at a reduced rate with 0% interest. All remaining balances are legally eliminated with a court discharge at the end of the program.
Tax Consequences: Any debt eliminated under the Chapter 13 plan is not subject to taxation, state or federal. Filing bankruptcy is a non-taxable event.
Impact on Credit: Counter to common belief, filing for bankruptcy (especially Chapter 13) will actually help to improve your credit over the course of the plan. While Chapter 13 is reported on your credit for 7 years after date of discharge, it does not IMPACT your credit for that length of time.
A Chapter 13 Plan has built-in functions to improve a client’s credit score during the course of the program. There are two main drivers of a credit score according to FICO:
- 30% based on your amount of total debt load
- 35% based on your payment history
A Chapter 13 Plan can reduce unsecured debts and focus payment efforts on paying down principal debt. The plan structures consistent and timely payments to creditors through a court-appointed Trustee. When you file a Chapter 13, it stops any more late payments reported to the credit bureaus.
DEBT MANAGEMENT PROGRAM (DMP)
Pros: A DMP provides a non-bankruptcy, non-loan option to reduce your interest rates and set up a repayment plan for unsecured debts. It is a viable option if the main concern is unsecured debt obligations and there is discretionary money in the budget to focus on repayment of principal debt.
Cons: The DMP only deals with and consolidates unsecured debt obligations. While in the DMP, you cannot access new credit or take out other loans. The DMP does not provide legal protection from creditor actions; it is a voluntary plan for your creditors. As such, one creditor opting not to participate can affect the entire process as the creditor may instead aggressively pursue collection including a lawsuit and garnishment. If you miss or are late on a payment, it could disrupt the repayment plan and end favorable interest rates.
A Debt Management Program or DMP is a structured debt payment program set up by a 3rd party company or credit counseling agency (CCA). The CCA works on your behalf with creditors to structure a repayment plan that works for both parties. In most cases, the agency will lower interest rates, eliminate late fees and consolidate everything into one monthly payment. Typically, they do not lower the principal amount owed.
As a part of the process, the 3rd party agency will access a budget, gather your list of creditors and begin taking payments. They withhold these payments to your creditors until terms have been negotiated. A DMP is used to consolidate unsecured debt obligations and does not assist with secured debts, student loans or tax obligations. Once the plan is activated, it is recommended that you call each creditors included in the DMP to verify that they have accepted the terms of the plan as proposed.
Legal Protection from Creditors: While the goal of the repayment program is to work with each creditor and strike optimal repayment terms, the creditors are not legally bound to accept the offered terms or continue to participate in the repayment process if they sell the debt or decide to withdraw their participation. While the DMP is active, they are still legally able to call you and communicate with you for collections; however there is less incentive for them to do so.
Debt Reduction, Resolution Tools and Terms: A key factor to understand and consider is that most debt management companies, although “non profit agencies,” do charge for their services. Also, many are funded by the major banks and credit card companies so they have more than one loyalty.
DMP repayment terms can vary and interest rate are typically negotiated down to 8 – 16%. The goal of the DMP is to lower interest rates, lower monthly payments and waive late fees and over-limit fees. The plans are typically designed to pay off the entire amount that you owe, generally within 3 – 5 years. The 3rd party or CCA does charge a monthly fee to administer the plan; the typical range is $5 - $75 per month. Most, if not all accounts, are closed for new charges while in the debt repayment plan. While in the DMP, you will generally be prohibited from opening new lines of credit.
All eligible unsecured debt obligations must be accounted for in a DMP, even if you are not behind or payments or don’t wish to include them. DMPs cannot include secured debts such as a mortgage, vehicle loan, or home equity loan; and student loan debt may not be included either. It is important to understand that missing a payment could derail the plan, end your interest rate cuts and trigger immediate creditor collection or legal action.
Tax Consequences: Since the DMP doesn’t typically include creditor forgiveness of principal debt, there are usually no adverse tax consequences.
Impact on Credit: Enrollment in a DMP is not a factor in credit scoring models, although it can affect other aspects of your credit that are common factors in the scoring models. This largely depends on how your credit stands when entering into a DMP. If you have largely been current on your payments (even just the minimum due) then your credit score may drop initially while in the DMP. This is because DMPs usually withhold payments to creditors as they are negotiating terms. This causes the “recent payment history” portion of your score to dip. Since it is the highest component of your credit score (35%), it may cause your score to decrease until this payment history is improved or restored.
The DMP plan may also change the payment dates made to creditors resulting in late payment reports to the credit bureaus. In addition, closing down accounts too quickly can negatively impact the credit score by changing your “Credit utilization ratio.” Closing accounts lowers the amount of credit you have available (your credit limit), which increases your credit utilization rate and negatively impacts your credit score.
Mandatory closure of credit card accounts will affect your credit utilization ratio, which is a common factor in credit scoring. Also, closing accounts will affect account age. This is the length of time you have been using credit and is a factor in most credit scoring models. Closing credit card accounts also reduces the types of credit in use which is often factored into credit scoring calculations.
The caveat here is that your credit score is primary used to obtain future credit with favorable terms. Since the goal is to reduce debt and establish repayment terms, you credit score will likely bounce back during the course of the repayment plan. Since you are prohibited from opening new credit while in the DMP, the short term dip in your credit score should not negatively impact your or be a long term factor.
CREDIT CARD DEBT CONSOLIDATION LOAN
Pros: With the right terms, a credit card debt consolidation loan (CCDCL) allows you to consolidate to a lower interest rate and pay down principal debt. With fewer bills to pay, a CCDCL can simplify your budget and remove the stress of monthly bill-paying.
Cons: In order to qualify for the best balance transfer rates, you must have good/excellent credit. The introductory or promotional interest rate is usually only a 6 – 18 month rate. If you cannot reasonably pay the principal debt down in that time period, the CCDCL may not help you to ultimately reach your goals. There is usually an initial 3 – 5% balance transfer fees.
Legal Protection from Creditors: This option does not provide legal protection from those creditors that are not paid off (balance transfer) with the CCDCL.
Debt Reduction, Resolution Tools and Terms: It is important to ensure that you are making headway with principal debt and not just paying interest each month. Be careful of low rates for promotion periods that balloon into high rates within a short period of time. Generally it is 18 months maximum that a lower promotion rate applies.
Once you know the length and terms of the favorable rate, it is imperative to create a manageable and realistic budget plan to pay down the debt before that rate expires. Interest rates can widely vary: 6% - 25% depending on your credit score. It is best to avoid new purchases on transferred balance loan as those purchases are usually charged at a higher interest rate.
Be sure you balanced budget is realistic and allows you to make on-time payments and maintain your other important bills such as transportation and living expenses.
Tax Consequences: There is no debt reduction aspect to a CCDCL so there are no resulting tax consequences.
Impact on Credit: If you are able to pay down principal debt through a lower interest rate, your credit score should improve. If you open up a new card to consolidate but keep the original card open, you will decrease your credit utilization (as you will have more credit available to you overall) and this action should also boost your credit score.
OTHER DEBT CONSOLIDATION (PERSONAL) LOANS
Pros: This option may lock in a lower interest rate allowing you to focus on repayment of principal debt. By consolidating smaller loans into one bigger loan, the budgeting and repayment process is simplified and less stressful.
Cons: In order to qualify for the best balance rates, you must have good/excellent credit. We don’t suggest variable interest rate loans as rates are always subject to increase and this could derail your ability to focus on principal debt repayment. If the loan is taken out against a secured asset (such as a retirement account or a home equity loan), the debt becomes secured and cannot be eliminated in a Chapter 7 bankruptcy.
We do not suggest using home equity or a loan against a retirement account to pay down unsecured debt obligations. By doing this, you are effectively converting unsecured debt, which could be eliminated under a bankruptcy if needed, to a secured debt or loans that must be paid back to avoid huge tax penalties. Keep in mind that if you default on a payment for a secured loan (such as a home equity loan); you could jeopardize loosing the home to a foreclosure.
Legal Protection from Creditors: This option does not provide legal protection from those creditors that are not paid in full with the proceeds of the consolidation loan.
Debt Reduction, Resolution Tools and Terms: Your credit score determines your interest rate or APR for a consolidation loan. Here are some recent estimates from a Nerdwallet lender survey:
- Excellent (credit score range 720 – 850) = estimated APR of 13.9%
- Good (credit score range 690 - 719) = estimated APR of 18%
- Average (credit score range 630 - 689) = estimated APR of 21.8%
- Bad (credit score range 300 -629) = estimated APR of 27.2% and lowest scores unlikely to qualify.
Repayment is typically 24 – 60 months. Personal loans offer some advantages over balance transfer credit cards. The payments are fixed to ensure timely pay-off and borrowing limits are typically higher.
Tax Consequences: There is no debt reduction aspect to a personal loan so there are no resulting tax consequences. If a loan is taken against a retirement account and not paid back or according to schedule, it can create significant tax penalties.
Impact on Credit: Personal loans may help improve your credit as you focus on paying down principal debt. A personal loan is reposted as “installment debt” to the credit bureaus, which is treated differently than revolving debt (such as credit cards) in the credit scoring formulas.
It is essential to find lasting debt resolution. The goal should be to pay DOWN debt, not just consolidate it. When you do this, you will improve your credit score by improving your debt-to-income ratio as well as presumably creating a positive payment history by your paying bills on time. These two factors alone account for 65% of your credit score! Find the option that works best for your unique circumstances. Creating a budget, sticking to it and starting a savings plan is next step to finding lasting financial freedom. Working to improve your credit score will allow you to qualify for better loan opportunities, lower interest rates and more favorable terms in the future.
Author - Christopher Jones, Esq.
Attorney Christopher Jones is a board certified consumer bankruptcy attorney. He is a partner at Acclaim Legal Services and has been licensed and practicing for over 14 years. He regularly participates in speaking and continuing education engagements for various organizations.
Acclaim Legal Services is a Michigan based law firm founded in 2003. They have an A+ rating with the BBB and an average 5-star rating with Google. They provide comprehensive debt resolution services including Chapter 13 bankruptcy (debt consolidation), Chapter 7 bankruptcy (debt elimination) and non-bankruptcy debt settlement options. They have 6 office locations throughout Michigan.
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