Many people in California are dealing with overwhelming debt that has proven problematic repaying. If you belong to this category of people, you should consider debt settlement and bankruptcy as your two strategies for repairing debt. The two approaches will have adverse effects on your future financial well-being. However, only one of these options is right for you. Choosing the best way to manage debt is not a walk in the park. At San Diego Bankruptcy Attorney, we understand that not every debt repair strategy will work best for you. As a result, we have discussed debt settlement vs. bankruptcy below to help you make the best choice when managing debt.
Debt settlement is a practice of repaying all your debt as a lump sum amount after a negotiation with a credit issuer outside the court. The strategy works by negotiating a payment that is less than the principal amount agreed upon initially on your unsecured accounts. If you ask a credit card company to accept a lesser amount than the original amount owed in exchange for repaying the debt in full, they will take the offer. Their decision is because the partial payment is better than risking a bankruptcy filing where you might deny them the opportunity to recover anything. When the deal is agreed, you can pay the amount in a lump sum or streams of payments.
Scenarios when Debt Settlement is Useful
Debt negotiation or settlement is not for everyone. It will be suitable for you if you are in the following situations:
- If you are not eligible for a bankruptcy filing
- If you are a low-income earner
- If you can’t pay the amount you owe in full
- If you are avoiding liquidation because of large numbers of assets
- When you are opposed to bankruptcy filing because of moral or religious reasons
How Debt Settlement Works
Creditors or debt collection companies consider a debt settlement option if you have several late and skipped payments of your credit card debts or second mortgage. Also, if you have many collection accounts, a creditor might be willing to settle for a lesser payment than you owe. But in case the creditor believes you can repay the amount you owe in full, then they are not going to settle for less.
A settlement is only going to work if the creditor realizes you stopped making payments and that you may not repay the outstanding sum at all. They allow you to open a savings account where you deposit money monthly. When the settlement company is satisfied that the amount is enough to clear the debt at once, they go to the creditor and negotiate so that you can pay a smaller amount than initially owed.
Debts Included in Settlement Programs
Not all debts are in the debt settlement program. Those that are accepted in the program include:
- Credit cards
- Private student loans in default
- Old judgments
- Old repossession
- Department store cards
Debt Settlement Risks
The process of debt settlement is not easy. A lot of risks are associated with the strategy. Some of these risks include:
- There is No Assurance of Success
There is no promise that the settlement firm will resolve your debt for a lesser amount. The reason being that some creditors are not willing to get into a negotiating table with individual companies. So, if you pick a settlement company that does not negotiate with your creditors, you might not succeed. Other debtors have been forced to pay a minimum of four accounts to receive benefits.
- Penalties and Interests Continue Accumulating
While you save to clear the amount agreed upon, the interest rates continue accruing. Also, you risk increasing penalty fees and late charges.
- You Pay a Fee Once the Debt Settles
The majority of these companies will charge you a percentage of the amount of debt they had resolved, depending on your debt balance when you joined the program.
- You will Pay Additional Fees
Aside from the fees you pay when you clear the debt, other charges are included. Such charges include money you pay when opening a savings account and maintaining it under the debt settlement program.
- Forgiven Debt might be Taxable
Any forgiven debt is deemed as income by the Internal Revenue Service. To mitigate this risk, you might want to consult with a tax professional.
Being Conscious of Fraud by Debt Settlement Companies
The majority of people overwhelmed by debt are desperate to clear it and plan their future finances. As a result, you might lower your guard, and settlement companies might exploit these vulnerabilities to make promises, which are often a scam. They will take advantage of you as a debtor by recommending that you put a stop to monthly payments to the creditor and instead save up and clear the whole amount as a lump sum in a short duration. Regrettably, for you, the creditors might not be patient enough until the money is enough to make the debt because the settlement plan does not bind them. The chances are you will be sued, and if the creditor wins the case, they can garnish your wages and seize your property.
In certain situations, the settlement company will claim that they are in negotiation with the creditor. However, all they could be doing is collecting monthly fees directly from your savings account. Avoid such scammers by looking for a debt settlement agency licensed to operate in California. A licensed agency is likely to observe the law.
Advantages of Debt Settlement
Creditors don’t have an obligation to enter into a debt settlement contract. But because it’s a better option than a bankruptcy where they might end up with nothing, they agree to a lesser settlement. Some of the pros of a settlement include:
- Avoiding bankruptcy on your report
- Solving your debt problem
- Pay a fraction of the amount you owe
- Negotiating with creditors, thus avoiding time wastage and expenses involved in bankruptcy
Disadvantages of Debt Settlement
Debt settlement can help you a lot, but again, it has its downfalls. Some of the pitfalls of a debt settlement include:
- Free Rider Problem
It is a considerable problem to convince a creditor or multiple creditors that you are unable to repay your debt. The majority of these creditors might request documents that prove your income, liabilities, assets, and expenses to determine if you can repay the debt or not. The problem with sharing this information is that the creditor might learn you have other debts, thus forcing you to repay the full amount.
- Demand to Liquidate Assets
During a settlement, creditors might ask you to take a second mortgage if you own a home or liquidate your assets to pay the debt.
- The Tax Hit
In debt settlement, you pay a lesser amount than you owed. If you settle the debt, California considers the amount of debt forgiven as income and will demand you to pay taxes on it. The creditor writes off the forgiven amount then issues you with Form 1099-C, which you send to the state or federal authorities. The written-off liability is then credited as income. The reasons why the written off or forgiven debt is considered as income are:
- The forgiven amount is economically equivalent to you earning money and paying the creditor. It is therefore deemed as income hence the reason for being taxed
- After the debt was written off, you received an economic benefit in the form of a written-off debt
- In the event you had paid the creditor, the amount would have been considered as income and therefore taxable. But because the creditor didn’t get the money, the tax authorities lost money. To recover the money, they tax you for the forgiven debt because they consider it an income
- Inability to Make the Payments
After the creditor has agreed to a lesser settlement and you decide to create streams of payment instead of a lump-sum, should you stop the payments because you have lost a job or you were injured, you will have breached the contract. The creditor is, therefore, free to sue you and garnish your wages, assets, and levy funds from your bank accounts.
Having seen these disadvantages, you have learned that debt settlement doesn’t always solve your debt problems. If it did, no one would file for bankruptcy.
If you are overwhelmed with debt and debt settlement doesn’t seem like the right strategy for you, then bankruptcy filing is an option you can consider. The problem with declaring bankruptcy is that it affects your credit report. There are two avenues you can use to declare bankruptcy. These are Chapters 7 and 13.
Chapter 7 Bankruptcy
Chapter 7 bankruptcy is a prevalent form of bankruptcy for small businesses and people who can no longer pay their bills. The challenge of this bankruptcy is that it damages your credit score, making it challenging to secure loans in the future. Also, you might end up losing your property. Chapter 7 bankruptcy (liquidation bankruptcy) is the legal procedure where the assets of the debtor are sold, and the money generated paid to the creditors to clear debts. Not everyone is eligible for a straight bankruptcy. To be eligible to declare liquidation bankruptcy, you must meet the following conditions.
- The amount you owe the creditor must total half your annual income
- You need not less than five years to repay the whole debt
- You have little or no revenue to disposes
- Your earn below the minimum level in California
- The debt interferes with essential aspects of your life
The good thing with liquidation bankruptcy is that once you qualify for this type of debt, there is a high probability that your debt is going to be discharged.
Pros of Chapter 7 Bankruptcy
Some of the benefits you can derive from filing for bankruptcy under this chapter include:
- It prevents your creditors from an aggressive collection or pursuing the debt
- The person who has declared bankruptcy is not expected to pay taxes on unpaid debts
- It enables you to keep most of the things you own
- It forces you to be financially disciplined
Cons of Chapter 7 Bankruptcy
Declaring bankruptcy under this chapter also has its downfalls. The downfalls include:
- Your credit score will be damaged for ten years
- You lose your credit cards
- You lose all your luxury possessions
- It exempts student loans and alimony payments
- If you are not eligible for liquidation bankruptcy, the court might convert it to Chapter 13 bankruptcy, where you pay your debts for up to five years instead of 4 to 6 months
Chapter 13 Bankruptcy
Under this chapter, you are allowed to restructure your debts and come up with a supervised three to five-year plan of debt repayment. The Chapter enables income earners to repay their debts as an alternative to liquidation. Persons who declare this type of bankruptcy are not unable to repay their debts. Their problem is dealing with all the demands of creditors immediately or at the same time. Chapter 13 allows you to submit a reorganization plan that protects your assets from being repossessed or foreclosed. Alimony, child support, unpaid taxes, and student loans are also non-dischargeable under this chapter.
Not everyone is eligible to file for bankruptcy under this chapter. For you to declare bankruptcy under Chapter 13, you must:
- Own more than three hundred and ninety-four thousand, seven hundred, and twenty-five dollars in unsecured debts
- Have more than one million, one hundred and eighty-four thousand, two hundred dollars in secured debts
- Demonstrate the ability to pay a debt
- Be current in your tax filing
If you succeed in filing for bankruptcy under this chapter, all foreclosure proceedings are suspended, buying you time to plan or restructure your finances to pay the debt. If you are scared you might lose your house or property because of debts, Chapter 13 bankruptcy is the way out.
Pros of Chapter 13 Bankruptcy
When you successfully file a petition under Chapter 13, some of the advantages you acquire include:
- It protects your property, including home or car, from foreclosure or repossession by creditors
- Once the debt has been repaid, the debt is discharged
- No tax obligation for the written-off debt
- The waiting period is two years before filing for bankruptcy, which is less than six years under Chapter 7.
Cons of Chapter 13 Bankruptcy
Aside from the advantages, Chapter 13 has its shortcomings. Some of the deficiencies are:
- It requires you to follow a supervised payment plan that runs for three to five years
- Your credit score is damaged for five years, making it difficult to get credit
Chapter 7 Vs. Chapter 13
Chapter 7 liquidates many assets of the debtor, but the advantages are that the process ends sooner because it lasts between forty-eight to one hundred and eighty days. The disadvantage of the process is that the foreclosures and repossession are temporary. When the case is concluded, creditors will come to pursue their debts.
On the other hand, Chapter 13 buys you more time to clear the debt and retain all your property. After Chapter 13 concludes, you can immediately file for liquidation bankruptcy to reduce the remaining debt. The disadvantages are that Chapter 13 takes longer to end, and the legal fees are high.
Effects of Bankruptcy and Debt Settlement on Credit
Both strategies damage your creditworthiness for years. For bankruptcy, any chapter you opt to file under will affect your credit score. Chapter 7 credit record stays for ten years, while that of Chapter 13 is in effect for seven years. Accounts associated with debt settlement will also be removed from your report after seven years.
In bankruptcy, Chapter 7 clears all your debt within six months, while Chapter 13 makes partial payments according to the supervised budget plan by the court. Debt settlement, on the other hand, requires you to make lump sum payments or making a stream of payments to a savings account then pay the amount in full to the creditor. There is no room for stopping payments once you have entered a debt settlement contract. Breaching the contracting by stopping payments can expose you to lawsuits, additional interest charges, and credit damage. The good thing with a settlement is that the creditor might agree not to report you to credit-rating bureaus once you have paid the debt. This allows you to safeguard or rehabilitate your credit score within a short period.
Other Ways of Repairing Debt
Though debt settlement and bankruptcy are excellent ways of repairing debt, there are other alternatives that you might want to explore. The other options include:
- Debt consolidation
- Credit counseling or debt management
- Continued making of minimum monthly payments to creditors
Find a San Diego Bankruptcy Attorney Near Me
The cost of living has shot up in California, making life difficult for many. Losing a job, being demoted, or suffering injuries makes the situation even worse. Debt repayment for many has become a problem. Fortunately, the San Diego Bankruptcy Attorney is here to help. There are several ways you can repair your debts. If you are torn between debt settlement vs. bankruptcy in servicing debts, we will help you pick the option that suits you. Reach out to us today at 619-488-6168 for a zero obligation bankruptcy consultation.