Nobody seeks out illness, job loss, divorce or any other financial catastrophe, but sometimes things happen. Many people will accumulate overwhelming debt loads as a result of such hardship. If the burden of your debt is too much for you to afford, what can you do? The worst thing to do is jump into a debt relief program without educating yourself.
In this guide, weâll explain the risks and benefits of the most common types of debt relief programs.
Chapter 7 bankruptcy, also known as liquidation bankruptcy, offers comprehensive debt relief. In liquidation bankruptcy, a court-appointed bankruptcy trustee sells certain assets (called unprotected assets), and the proceeds are used by the trustee to repay your creditors. Following the distribution of funds, the court discharges the remaining eligible debts. That means you no longer owe the debt and collectors cannot contact you about the debt. Debts that the court wonât discharge include: income tax debt thatâs less than three years old, child support or alimony payments, student loans and fees and penalties owed to the government.
Although Chapter 7 bankruptcy requires selling off your valuables, filing may not leave you penniless. Filers can keep protected assets, such as personal items and money in retirement accounts. Most states allow filers to keep a small amount of cash and some amount of equity in vehicles or homes.
Chapter 7 bankruptcy is available to anyone earning less than the median monthly income for a family of your size in your state. If you earn more than the median income, you may qualify for Chapter 7 bankruptcy through âmeans testing.â The means test shows whether you have enough income to cover a debt repayment plan that Chapter 13 bankruptcy requires.
Being eligible for Chapter 7 bankruptcy doesnât mean itâs a good idea for you. Some people have too many unprotected assets to make Chapter 7 bankruptcy a reasonable option. Chapter 7 bankruptcy may force people into selling paid off cars, tools for operating their business or other important assets. In those cases, Chapter 13 bankruptcy or other types of debt relief may be a better option.
The amount youâll pay for Chapter 7 bankruptcy depends on a variety of factors, including where you live and the complexity of your case.
You can expect to pay $1,100-$1,200* in attorneyâs fees when you file Chapter 7 bankruptcy, according to Lois R. Lupicaâs Consumer Bankruptcy Fee Study. Filers must also pay filing and court fees, which adds several hundred dollars to the cost of bankruptcy. In general, all fees have to be paid before your attorney will file your case.
*Numbers adjusted for inflation.
Following bankruptcy, your credit score will drop, but itâs not necessarily a death sentence. Bankruptcy stays on your credit report for 10 years after filing, but your credit score can recover. You can take steps to grow your credit score immediately following Chapter 7 bankruptcy.
In some cases, bankruptcy filers choose to reaffirm debts as part of the bankruptcy agreement. That means they agree to continue paying certain loans (such as a car loan or mortgage) as agreed. Making those payments can increase your credit score over time. Making timely payments on a secured credit card can also help you rebuild your score.
Filing for bankruptcy becomes less significant as time passes and you continue to display positive financial management on your credit report.
Aside from Chapter 7 bankruptcy, many consumers file Chapter 13 bankruptcy. Chapter 13 bankruptcy allows you to keep all of your assets, but it comes with a downside. Chapter 13 bankruptcy involves a debt payment plan that lasts three to five years. On top of that, the fees for Chapter 13 bankruptcy can be much higher than the fees for Chapter 7 bankruptcy.
A debt management plan is a new payment schedule for paying off existing debts. These plans are created and administered by nonprofit credit counseling companies. Under the plan, credit counselors will consolidate your credit card debts, unsecured personal loans and bills in collections into a single, monthly payment. Youâll pay the credit counseling agency instead of paying creditors directly.
The credit counseling agency doesnât just consolidate debt, it works to reduce your monthly payment. The agency may be able to reduce interest charges, get old fees waived and even extend the length of time you have to pay a loan. âMost of the time, people see smaller monthly payments when they go on a debt management plan,â said Robby Dunn, vice president of counseling at the nonprofit company, Consumer Credit Counseling Service of Buffalo.
In general, when you agree to a debt management plan, your creditors close down your lines of credit. This means that you cannot use your credit cards during the repayment plan. Dunn told MagnifyMoney that some people keep one credit card with a low balance off the debt management plan. This allows people to keep a source of credit available for emergencies.
When you start a debt management plan, youâll have to close every credit card account you have, even accounts that are in good standing. This reduces your length of credit history and results in an immediate drop in your credit score; however, most people can regain the lost points in six to twelve months.
Itâs imperative that you stick to your repayment plan and donât miss any payments. Your credit counseling agency wonât be able to pay your creditors if you donât pay them, which doesnât leave you with many good options. âItâs important to understand that your creditors arenât likely to be empathetic toward you. They expect to get paid,â said Dunn.
Creditors that donât get paid may drop out of the debt management plan and report that youâre no longer paying as agreed. The creditors may also attempt to collect your debts through other means.
Many people confuse nonprofit credit counseling companies with for-profit debt settlement companies. Debt settlement companies do not offer credit counseling services, and instead, work to help you pay off debts that are already in collections.
When you settle debt, you agree to pay a creditor a portion of the debt you owe. In exchange, the creditor wonât sue you for the remaining balance. Most of the time debt settlement companies can only help you settle the debt thatâs in collections.
Debt settlement companies will negotiate with creditors on your behalf. Although these companies work for you, the amount you ultimately pay depends on the creditor, your income, how long youâve owed the debt and the type of debt you owe.
For example, credit card lenders may be more willing to settle your debts than business lenders. Additionally, debt settlement attorneys may be able to reduce the amount you owe on private student loans, but thatâs not possible with federal student loans. Yesner estimates that most credit card companies settle for an average of 30%-35% of the debt amount owed, but heâs quick to point out that the range varies widely case to case.
Itâs a good idea to have a solid understanding of the debt settlement process before you start working with a debt settlement company or attorney. If you donât have upfront cash savings â a requirement for some companies â they may want you to set up a dedicated savings account to pay fees and funds. Legally you will own the funds in this account and have complete control over the account at all times.
Other companies may be willing to work with you to negotiate new payment plans. Tayne explained that she negotiates installment plans on behalf of her clients. Through her negotiations, she aims to reduce the interest rates to 0% and reduce the principal balance to a manageable amount; however, thatâs not always possible to achieve.
Debt settlement companies may also ask you to change how youâre handling your creditors. If youâre paying debts as agreed, a debt settlement company may advise you to stop paying your debts.
The fee structure of a debt settlement attorney or company will heavily affect your overall costs. âYou only want an attorney that works on contingency. They should be compensated based on how much money they save you,â Tayne said. Contingency fees (fees based on a percentage of savings) incentivize your attorney to negotiate the amount you owe as low as they can. If the fee isnât based on a negotiated savings rate, it will be based on a percentage of your overall debt load prior to negotiations.
Debt settlement companies cannot legally charge you any money unless they have successfully negotiated at least one debt for you. You must pay your creditor before the debt settlement company can collect its fee.
Thereâs no doubt that settling your debts will affect your credit score; however, exactly how much it affects your score is difficult to estimate. Once an account is in collections, settling the debt will not cause any further damage to your credit score. However, defaulting on an account thatâs on a debt settlement plan could cause substantial harm to your credit score.
âIn most cases, [your credit score] will go down, but it wonât go down permanently. In some cases, settling debts could actually raise your credit score. If you have a score in the low 600s with all your accounts in default, you might see it go up right away,â said Tayne.
Strategically defaulting on debt may sound reasonable, but it can expose you up to a variety of risks. When you stop paying your bills, your creditor may charge you higher fees and interest. If you canât successfully settle the debt, youâll owe more than you did before.
Defaulting on debt will lead to negative marks on your credit report. Negative information will stay on your credit report for seven years. Settling already-defaulted debt wonât harm your credit any further; however, defaulting on a current debt account could cause your credit score to take a big hit.
Finally, your creditors may sue you if you default on a debt. Due to legal risks, Tayne recommends working with a debt settlement attorney rather than a debt settlement company. âYou need someone who understands how to handle the legal risks appropriately,â she said. âItâs not enough for a company to say âWe have an attorney on staff.â Itâs better to know that an attorney will handle legal matters.â
Creditors may be more willing to work with individuals than debt settlement companies, but settling debts on your own presents its own risks.
The CFPB sets out a three-step process for negotiating settlements with your creditors. The process recommends understanding your debts, proposing a solution and negotiating a realistic agreement. During the final step, the CFPB recommends enlisting the help of an attorney or credit counselor to help you with the negotiations. âSettling a debt sounds simple; you simply call up a creditor and work out a settlement. In reality, it can be a lot of work. It can take three or four hours just to start talking with the right person,â explained Tayne.
âYouâre probably smart enough to do this on your own. The real value that I bring is that I do this day in and day out. Sometimes itâs just more efficient to pay someone else,â added Yesner.
That said, if money is tight, settling debts on your own could be the right option for you. Below we explain how to work through your own debt relief program.
Making your own debt relief plan may seem overwhelming, but it is possible to find debt relief without paying for outside help. Use the following tips to be successful with your own debt relief plan.
A DIY debt relief plan requires executing a well-thought-out plan. This isnât easy if youâre constantly hounded by calls from debt collectors. Put a stop to creditor harassment instead of sending your money to the most threatening collector.
The CFPB provides sample letters that can help you deal with debt collectors. These letters can stipulate when and how a debt collector can contact you. While collectors can still sue you, they cannot legally contact you.
Once you have the creditors at bay, the first step in resolving your debt is knowing what you owe. Specifically, you will need to know how much money you owe, who owns the debt, the interest rate on the debt, the minimum monthly payment on the debt and whether the debt is in good standing. You can find most of this information from your credit report (which you can get for free from AnnualCreditReport.com).
You can find the exact amount you owe and the interest rate on current debts from the most recent billing statements from your lenders.
Debts in collections may seem like the most pressing matter, but most of the time youâll want to deal with current accounts first. Once a debt is in collections, it has already damaged your credit score. Only time (and adding good credit information to your report) will fix the damage.
Unless a creditor sues you, youâll want to put your money toward debt thatâs still in good standing before dealing with debts in collections. This guide offers step-by-step guidance on how to eliminate credit card debt as fast as possible.
Itâs important to note that dealing with current debts isnât always a matter of making minimum payments on all your loans. If you have student loans, you may want to consider opting into an income-driven repayment plan. These plans will reduce your monthly payments, so you can put more money toward high-interest credit card debts.
For credit card debts, unpaid medical bills and other related debts, you may want to consider a debt consolidation loan. Debt consolidation loans are unsecured personal loans with fixed interest rates and fixed repayment schedules. They allow you to roll all your payments into a single payment, reduce your interest rate and (in some cases) increase your credit score. Debt consolidation loans are an effective option for people who have enough income to support the monthly loan payments.
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Once youâve paid off your debts that are in good standing (or youâre easily able to make your monthly payments), you may want to work toward paying off bills in collections. Paying off bills in collections wonât improve your credit score, but it can help you avoid lawsuits.
Before you reach out to your creditors, youâll want to create a budget that shows you how much you can put toward debt thatâs in collections each month. A certified credit counselor could help you create a budget if you need help. A credit counselor or a consumer advocacy attorney may also be able to advise you if the statute of limitations on your debt has expired. When the statute of limitations on debt expires, debt collectors can no longer sue you to collect.
If you determine that you still want to pay off your debt in collections, you can propose your payoff plan to your creditor. Do not put any money toward debts in collections unless you get a payoff agreement in writing.
Although a DIY debt relief plan is a low-cost way to get rid of debt, you may need help. If a creditor or debt collector sues you, youâll want to contact a consumer advocacy attorney. Donât ignore lawsuits, or your creditor may win a judgment against you.
If you choose to work through overwhelming debts on your own, you could run into some scams. The following are red flags that someone or some company might be trying to scam you:
If youâre struggling to make your monthly debt payments, or youâre overwhelmed by calls from collection agents, youâre a good candidate for some sort of debt relief. Seeking advice from a bankruptcy attorney or a certified credit counselor is a good place to start. When you know more about your debt relief options, you can make a plan to get back on track financially.
Even if youâre making on-time payments on most of your debts, you may still benefit from a debt relief plan. Those with debts in good standing may find relief from debt management plans, consolidating your debts or by taking advantage of promotional balance transfers.
Whether youâre struggling to make payments, or youâve already defaulted on your debts, debt relief could be right for you. The sooner you start your research, the sooner youâll get yourself back on the right financial foot.
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