As consumers are still feeling the economic impacts of higher prices caused by inflation, struggling with record credit card debt and facing increased borrowing costs from higher interest rates, many are seeking debt relief options. The two most common forms of debt relief available are bankruptcy and debt settlement. First, we will examine bankruptcy and then turn to the issues posed by debt settlement.
Understanding Bankruptcy
Bankruptcy is a federal legal process that provides debt relief and stops all collection activity through an automatic stay that takes effect immediately upon the filing of a bankruptcy petition. In contrast to debt settlement, recognizing a bankruptcy filing is not optional and all creditors must comply with an automatic stay or risk facing significant consequences. The two main types of consumer bankruptcy are Chapter 7 and Chapter 13, each suited to different financial situations.
Chapter 7 Bankruptcy
Chapter 7 is the fastest way to eliminate most debts, most commonly credit card balances, personal loans, medical bills, as well as auto loan deficiencies. After filing a bankruptcy petition, an automatic stay goes into effect that prohibits all collection actions including lawsuits, creditor calls, texts and emails, bank levies and wage garnishments, and can also stop foreclosure sale dates. Approximately 4-6 weeks after filing, debtors are required to attend a brief hearing called a 341(a) meeting before a court appointed Trustee, which is conducted remotely via Zoom. Once the hearing is complete, most cases end with a discharge issued by the court a few months later. In Chapter 7 bankruptcy, the vast majority are considered to be “no asset” cases since a debtor’s assets can be protected though various bankruptcy exemptions. Most secured debts are also discharged in Chapter 7 bankruptcy. However, the lien or security interest will remain on the secured asset, and the creditor may still repossess the collateral or pursue foreclosure if payments are not made. The eligibility for chapter 7 depends on a debtor’s income and expenses, and if it applies, the bankruptcy Means Test. Chapter 7 offers quick debt relief, protection for exempt assets, no negative tax consequences on discharged debt, and the ability to rebuild credit soon after discharge. In cases where a debtor does not qualify for Chapter 7 or they have valuable assets that are not protected by bankruptcy exemptions, they may instead seek debt relief through Chapter 13 bankruptcy.
Chapter 13 Bankruptcy
Chapter 13 is designed for individuals with regular income, including those who do not qualify for Chapter 7 because they fail a bankruptcy means test or debtors who have sufficient income to pay back creditors through a Chapter 13 plan, or those who want to protect a valuable non-exempt asset (such as real estate with equity above the exemption amount) that they would risk losing in a Chapter 7 case. The chapter 13 process also provides an automatic stay to protect the debtor from creditors and involves a court-approved repayment plan typically lasting 36 to 60 months, with a monthly payment made to a bankruptcy trustee who pays the claims of the creditors once the plan is confirmed by the Court. Debtors may only have to repay a percentage of what they owe, particularly when creditors fail to file claims within the proscribed time limit. Most debts are repaid without interest, and remaining eligible debts are discharged at the end of the plan. Additionally, Chapter 13 is especially helpful for homeowners facing foreclosure as it provides a stay against foreclosure proceedings and enables the debtor to pay back past due mortgage payments through the Chapter 13 plan. Debt settlement programs certainly cannot provide this.
Understanding Debt Settlement
Debt Settlement is a for profit industry and many of the participating companies describe themselves as offering a “program” to resolve outstanding credit card debts and loans. However, they are not programs at all and are not endorsed or sanctioned by any government agencies. In debt settlement, a debtor hires a company, many of which heavily advertise on tv and the internet, to negotiate lower payoffs or “settlements” for each account included in the “program”. They may characterize their programs as debt consolidation because they are offering one monthly payment, but they are not offering a debt consolidation loan or providing a credit counseling service. On the contrary, the companies, which often include National Debt Relief, Freedom Debt Relief, JG Wentworth and many others, that are often based outside of New York, will advise the debtor to stop paying their bills for the accounts included in the program and to start making monthly payments into their special escrow account.
The objective of a debt settlement program is to build up sufficient funds in the account which can then be used to pay the settlements with creditors, who may be more willing to settle delinquent accounts. Usually, an account has to be at least 6 months past due before a creditor offers any meaningful settlement reduction. This process can often take years to complete and can be devastating to a debtor’s credit. Furthermore, while the negotiation process takes place, the debtor will be deemed delinquent and placed into the debt collection process which can include being barraged by debt collection calls and lawsuits from creditors. Those lawsuits can result in judgments, which can be used to garnish a debtor’s wage, restrain a bank account and be placed as a lien against the title of a homeowner.
Some debtors may confuse debt settlement with debt consolidation, where a debtor takes out a lower interest loan to pay off high interest debt. Both forms of debt relief may lead to lower monthly debt payments every month, but debt settlement leaves the debtor with delinquent accounts in collection and damaged credit from defaulting on their payments. Furthermore, by the time many debtors look for a consolidation loan, many already have damaged their credit and are unable to obtain a low interest rate on their consolidation loan.
Bankruptcy is Often a Better Debt Relief Option than Debt Settlement
Many debtors often unnecessarily delay filing for bankruptcy because of the perceived stigma from it, so they consider it a last resort. However, it often should be an option pursued much sooner. “The principal purpose of the Bankruptcy Code is to grant a fresh start to debtors.” Marrama v. Citizens Bank of Mass., 549 U.S. 365, 367, 127 S.Ct. 1105, 166 L.Ed.2d 956 (2007). Often, when a debtor is struggling financially, their best option for debt relief is bankruptcy. It provides quick debt relief, and a debtor is still in position to rebuild their credit post filing. Unfortunately, thanks to slick and aggressive marketing campaigns, many debtors initially attempt debt settlement. In fact, many clients who retain our office for bankruptcy representation have already attempted debt settlement to resolve their financial issues but failed.
Based upon our clients’ experiences and other research, we have found the following:
- Debt settlement programs did not protect enrollees from creditors or stop collection calls or lawsuits,
- Debt settlement programs are very expensive,
- The actual savings were insufficient when combined with the program’s costs and actual settlements obtained,
- The program did not clearly advise of the possible negative tax consequence of debt settlement and
- Our clients wished they had contacted a bankruptcy attorney sooner. They had seen bankruptcy as their last option, when it should have been their first option.
Seven Important Things to Know About the Risks of Debt Settlement
First, debt settlement programs are not sponsored or endorsed by any government agency. Despite marketing themselves as “programs”, the government is not involved in these programs in any capacity. In fact, the industry has faced scrutiny of their practices by the Consumer Financial Protection Bureau and various state Attorney General offices.
Second, debt settlement programs do not protect their enrollees from creditors. They do not legally prevent lawsuits, judgments, garnishments or bank accounts from being frozen. Bankruptcy, on the other hand, provides an automatic stay that prohibits all debt collection activity and is strictly enforced,
Third, debt settlement programs can take years to complete. Chapter 7 bankruptcy is a relatively quick process and typically is over in a number of months. Chapter 13 bankruptcy can take 36 to 60 months to complete, but it offers protection from all creditors while it is pending.
Fourth, creditors are not required to participate in debt settlement programs, and many opt not to participate. In bankruptcy, all creditors must recognize a bankruptcy filing and comply with federal bankruptcy rules.
Fifth, outstanding debt balances in a debt settlement program can balloon with default interest and late fees while pending in a debt settlement program. Chapter 7 bankruptcy quickly discharges most debt and Chapter 13 bankruptcy allows a debtor to pay back most debts interest free. Furthermore, often, not all creditors file a claim in a Chapter 13 bankruptcy case due to the short period of time allowed or for other reasons. Any debt included in Chapter 13 case, where a creditor does not properly file a claim, would be discharged just like in Chapter 7 case, once the plan is complete.
Sixth, after taking a debt settlement program’s fees and tax consequences into account, these programs often provide almost no to minimal actual savings. Many of these companies charge 25% or more of the outstanding balances as their fee and not based upon what is actually saved. In addition, any debt savings that is forgiven exceeding $600 may result in a 1099-C being issued by the creditors. The IRS views this debt forgiveness as income, and the debtor may be responsible for paying taxes on it. Conversely, there are no negative tax consequences from debt forgiven in a bankruptcy. Additionally, years ago debt settlement programs were often able to obtain more favorable settlement results. Now from what we see, creditors often want 50% or more, even up to 75% of an outstanding balance. This is much higher than in prior years.
Finally, who would you rather use to handle your important financial wellbeing and data, a licensed attorney or an unlicensed sales associate or representative at a debt settlement company. Having an experienced attorney who is a member of the bar and bound by an ethics code is much preferable to using someone who is not and may misrepresent what their “program” can achieve.
Contact The Law Offices of David I. Pankin, P.C.
If you are struggling financially and considering debt settlement, you should speak with an experienced bankruptcy attorney before engaging with a debt settlement company. For a free consultation, you can contact the Law Offices of David I. Pankin, P.C. at (888) 529-9600 or through our easy online contact form. We have over 28 years of experience helping debtors achieve a fresh financial start and represented over 15,000 clients along the way.
