Debt consolidation is of the things many of our clients consider before filing bankruptcy. And when some of them hear about Chapter 13 bankruptcy, they ask, “Well, why wouldn’t I just do debt consolidation then, and save my credit score?
It’s an excellent question, and one we can answer by the numbers.
Debt Consolidation With a Settlement Company
When you take the debt consolidation option you work with a company who is going to charge you a fee. These fees generally range from 15% all the way up to 25%.
Some of these companies may try to settle your debts instead of paying them all the way off. And that might sound like a good deal too.
According to CNBC, Americans have $38,000 in personal debt on average in 2019. Most debt settlements hover in the 60% to 80% range, depending on the age of the debt. Keep in mind very new debts almost never settle, but we’ll be generous for this exercise and say all your debts can be taken care of this way. We’ll call the settlement an even 70%.
That means you’ll have $26,600 left to pay off. You’re going to pay another $5,200 in fees. If the debt consolidation company puts you on a 5-year plan, you’ll end up paying $530 a month. This math all assumes all this debt is interest-free. Total amount paid: $31,800, almost as much as if you’d never settled at all.
Meanwhile, your credit score is plummeting, because you’re putting notation after notation on your credit report that says, “Debt settled for less than the full amount.” And since they’re settling them one by one, creditors will continue to call. And they can still sue you if they see fit.
There is a version of this type of company that tries to make micro-payments to creditors much like a Chapter 13 trustee would. Rest assured creditors are not satisfied by receiving tiny amounts of money. Collection activities will continue. Companies who claim to have some sort of special insider relationship with collectors or credit card companies are usually embellishing the truth. They might have a point of contact at each of them, but it’s unlikely they have the special privileges they’re implying.
Consolidating Your Debt With a Loan
Another common way people consolidate their debts is by taking out a loan, or a making a balance transfer. Home equity loans are by far the most common way to get this done.
So perhaps you take out the same $38,000 in debt and transfer it to a home equity loan at today’s interest rate, which is 3.92%. Your payment may be higher or lower depending on the term of the loan, but we’ll call it a 10 year loan, the lowest one generally offered. Your payments will be $383 a month. Does it seem like a good deal?
But remember, you’re not paying back $38,000. You’re paying back $38,000, plus interest. By the time you’re done paying off this loan, you’ll have paid a grand total of $45,995.
This move may preserve your credit, but it’s dangerous. You’ve just converted a bunch of unsecured debt, much of it interest-free because it’s sitting in collections, to secured debt. If you can’t pay the $383, the lender can foreclose on your house just like your original mortgage lender can. And if you’re already three steps away from financial ruin, it only takes one emergency to make a payment of nearly $400 a month untenable. You are now worse off than you were before.
Want to take out a 30 year home equity loan to drive those payments down? You’ll only pay $180 a month, but you’ll be paying it for the next 30 years. And when your 30 years is up, you’ll have paid a grand total of: $64,681, nearly double what you paid before.
And either way, this strategy only helps you if you never have to take out any additional debt for any reason. As soon as you take on a new debt your total debt load is no longer consolidated, you’re again juggling multiple payments, and you’re even deeper in the hole.
Chapter 13 Bankruptcy
When you go into Chapter 13 bankruptcy, you, your attorney, and the bankruptcy trustee will take a look at your family budget. We’ll make sure you have food, shelter, clothing, and all the other essentials taken care of first. Then we’ll look at what’s left over.
You could propose the same $180 payment to the trustee, and depending on how much you make it may well be acceptable. Perhaps it’s a little higher, at $250 a month.
No interest is accruing. There are no fees other than the filing fees associated with bankruptcy, and your legal fees, both of which are far smaller than debt consolidation fees or loan costs.
Let’s use $250 a month. At the end of your 5-year term you’ll have paid $15,000, plus filing fees and attorney fees. Your trustee will distribute that month after month. At the end of 5 years, you receive a discharge, with all your debts wiped out.
Your credit score increases, because all those items are no longer sitting on your credit report.
You don’t pay any taxes on the $23,000 you did not pay your creditors.
And throughout that 5 year period you are protected by the automatic stay, which means creditors can’t call you, sue you, or take any of your property.
Which option makes more sense to you?