Almost everyone who owes more than they can pay wants to find an effective alternative to bankruptcy.
There are lots of outfits out there who’d like to “help” you to that… for a price.
But not everyone offering to help you get control of your finances has your best interests (as opposed to their own) at heart.
Be a savvy consumer of debt counseling or debt management programs.
Should you consolidate your debts
A loan to consolidate all of your debt into a single obligation is appealing. Write one check a month at a lower interest rate.
But first, make sure that you can really repay that amount. Consolidation doesn’t lower the total you owe.
Understand clearly the term, interest rate, and fees associated with the loan. It may be that even lowering the interest rate does not make your present debts manageable, it just postpones the day of reckoning.
Find out whether the loan will pay off over the life of the loan, or whether you will owe a “balloon” payment at the end. For most borrowers, balloon payments are just an invitation to another loan, and you never get free of this debt!
Home equity loans put your home on the line
If you can’t pay your present unsecured debts, all your creditor can do is sue you and try to collect any judgment it gets.
If you can’t pay your home equity loan, you may lose your house in foreclosure.
Most states provide an exemption that protects a given amount of equity in your home. The exemption puts that equity beyond the reach of your creditors.
If you voluntarily pledge that equity to a home equity lender, the exemption no longer protects the pledged portion of your home’s value.
If you participate in a program where a service negotiates with your creditors or makes payments on your debts for you, understand what they are doing.
Does the service promises to lower the total you owe or the interest rate you pay, or just promises to lower the payments you make every month, without significantly changing your obligation.
Know what happens if a creditor won’t negotiate. You may find yourself sued.
The debt settlement model where you set aside money with a third party who will attempt to negotiate a reduced payoff seldom solves the entire problem. The plan usually fails because some creditor holds out and won’t compromise. That’s why the debt settlement company pays themselves first.
In our opinion, the plan is bound to fail.
Make sure the program deals with all your debt
Some debt counselors confine themselves to dealing with your unsecured commercial creditors. They exclude your obligations for non dischargeable child support, unpaid taxes, or the crushing car loan.
In effect, they ignore the debts that are most important, while channeling your money to creditors whose claims could be discharged in bankruptcy. That’s backwards.
There are several debt management programs with modest cost to you, the client. Approach fee-based services with caution and make sure that the service is worth what it costs.
Many debt counseling programs advertising themselves as “non profits” may be fronts for profit making entities more interested in their own pocketbook than yours.
Chapter 13 is a more reliable alternative.
Beware of tax consequences
The IRS treats debts that are forgiven or reduced, outside of bankruptcy, as taxable income.
That means that if your creditor agrees to settle the debt for 50% of what you owe, the other 50% will be reported to the IRS as income, just as if they had written you a check for that amount!
Under some circumstances, you can avoid tax on cancellation of debt income, but it raises a complicating factor when you compromise debts outside of bankruptcy. See COD income.
Make sure that you don’t worsen your situation by enlisting others to help with debt management. While it is comforting to have an ally in your struggle to pay your bills, make sure that their help is really helpful.
Remember that Chapter 13 is a repayment plan in which you propose the percentage that you can repay creditors and upon confirmation, the court makes it binding on creditors.
Who to pay when money is tight
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