As a bankruptcy attorney, I am often asked questions about consolidating debts, such as, “How does debt consolidation work?” and “Can I do this to avoid filing bankruptcy?” To be honest, many people who are dealing with debt problems think about debt consolidation loans or other similar solutions at some point. Most people begin wondering how debt consolidation works when they are searching for a way to make creditors and debt collectors stop calling and sending threatening letters. Others begin to explore debt consolidation options only when they are served a lawsuit.
When clients ask me how debt consolidation works, I first begin by explaining the difference between a debt consolidation loan and the use of a debt consolidation company. Before diving into these differences I make an extremely important point: these options generally only work in situations where individuals have the ability to repay their debts, or at the very least, a significant portion of them. There are very few cases where we find that debt consolidation is the best option for solving overwhelming debt problems. To illustrate, let me explain each option and give examples of when it will work and when it is often better to file a bankruptcy.
How Does Debt Consolidation Work?
In order to answer this question, we must first distinguish between debt consolidation loans and debt consolidation companies.
Debt Consolidation Loans
With a debt consolidation loan you borrow a specific amount of money to pay off all of your unsecured debts so you end up with one monthly payment. Two problems with using a debt consolidation loan to solve debt problems are:
- You must have collateral to secure the loan (most companies will not loan you a large amount of money without collateral because your credit score is likely suffering from the financial problems that led you to this point) and
- You must have sufficient income to pay the monthly loan payments; otherwise, you will lose the collateral you have secured in your loan.
Most individuals do not want to risk putting up their home or other assets as collateral for a debt consolidation loan – because they don’t want to risk losing them. Furthermore, if you have been struggling to pay your bills for an extended period of time, your credit score is probably low, which makes it difficult to obtain a low interest rate (even if you qualify for the loan). Lastly, as stated above, if you default on the loan payments (which may be likely if you are already struggling with paying the bills you have before the consolidation), you will lose the collateral and probably have a deficiency judgment for the remaining balance on the loan after the collateral is liquidated.
On the other hand, if you qualify for a Chapter 7 bankruptcy case, you can discharge most, if not all, of your unsecured debts. The result is a fresh start so you can begin rebuilding your finances. In many instances, debtors benefit more from filing a Chapter 7 bankruptcy case than from trying to solve their debt problems with a debt consolidation loan.
Debt Consolidation Companies
Debt consolidation companies work with their customers to negotiate reduced amounts or payments with your creditors. The company collects one monthly payment from you and then uses that money to pay your creditors. There are several problems with this solution:
- Debt consolidation companies charge monthly fees for this service which adds to the cost that you pay each month;
- Creditors cannot be forced to work with debt consolidation companies and are under no obligation to accept a reduced amount;
- Any creditors that do not agree to negotiate the amount owed or work with your debt consolidation company will continue collection efforts against you, including but not limited to, filing lawsuits;
- You must have sufficient income to make the monthly payment in full and on time to your debt consolidation company (that amount could increase as each creditor is added to the plan); and,
- The amount that the creditor does not receive will be treated as income when you file your tax return.
If, on the other hand, you file a Chapter 13 bankruptcy case, all of your creditors must work with the bankruptcy court to resolve issues. Your creditors cannot continue collection efforts, including foreclosure, repossession or lawsuits (as they can with a debt consolidation company). Through a debt consolidation company you will likely continue to pay interest on your debts; through a Chapter 13 plan you will not pay interest on unsecured debts. Plus, once you complete your Chapter 13 plan, the remaining unsecured debts will be discharged and you will not be required to treat the discharged balances as income.
One of the best advantages of filing a Chapter 13 case rather than dealing with a debt consolidation company is that you are dealing with a Chapter 13 trustee who will make payments to your creditors each month. The trustee is supervised by the United States Trustee’s Office and his or her records are periodically audited to ensure they are accurate. A debt consolidation company is privately owned so you do not know until it is too late if your creditors are not receiving their payments each month.
Debt Consolidation vs. Bankruptcy
While debt consolidation may work for individuals who have sufficient income to repay their debts and collateral to secure a loan, in most cases, it is not the best solution to debt problems. The easiest way to find the best solution for your specific debt problems is to do thorough research and consult with an experienced bankruptcy attorney. Whether or not bankruptcy is right for you, a bankruptcy attorney will have insight and knowledge that will help you make the right decision.