DEBT CONSOLIDATION, DEBT MANAGEMENT, DEBT RESOLUTION WHAT’S THE DIFFERENCE?
In my prior article, we explored the various options for resolving debts, which can run the gamut from doing nothing to filing bankruptcy. Doing nothing is not an option for most individuals. And many people are reluctant to file bankruptcy. So let’s take a more in-depth look at the various other options.
Simply stated, debt consolidation is “the act of combining several loans or liabilities into one loan. Debt consolidation involves taking out a new loan to pay off a number of other debts. Most people who consolidate their debt usually do it to attain a lower interest rate, or the simplicity of a single loan.” See http://www.investopedia.com/terms/d/debtconsolidation.asp#axzz2FNj7RySE
The most typical example of this is where someone has high interest rate credit cards. If the debtor has enough equity in his/her home, the debtor will take out a home equity loan or loan from their 401(k) or IRA and use the proceeds to pay off their debts. The debtor must then repay the loan, usually at a much lower interest rate than the credit cards.
The advantage of this is that the debtor who can qualify for a lower interest rate can use the funds to pay off higher interest rate credit cards. Another advantage is that life is a little simpler as the debtor now just has one bill to pay rather than several. However, I am not a fan of this method of debt resolution. For one thing, where someone is borrowing equity from their home, they are taking unsecured debt and turning it into secured debt. We are living in uncertain times and many of us are just one paycheck away from losing a job. If any calamity – whether medical or job-related happens, what then? A debtor with a home equity loan is at risk of losing the home if payments are not made.
Moreover, home equity loans are not as prevalent as they once were prior to the 2007-2008 economic meltdown. Lenders now have more stringent standards and for people with credit issues and less than stellar credit scores, these kinds of loans may be very difficult to obtain. Not to mention the fact that housing values in some areas of the country were part of the housing bubble in that their values were inflated. When the bubble burst, many people found themselves without any equity to tap. Housing values still have not recovered sufficiently so as to allow debtors to start treating their homes as ATM machines again.
Borrowing from a 401(k)/IRA has somewhat similar consequences. These investment vehicles are there to provide for retirement and be a supplement to Social Security. Again, I am not a tax lawyer, but there are tax consequences if withdrawals are made from an IRA prior to age 59 ½ and there is no other exception. Consequently, a debtor who withdraws funds from a traditional IRA will not only have to pay tax on the money but will also have to pay a penalty if below the age for withdrawal. For 401(k)s, these loans must be repaid or else the debtor will be subject to taxation too.
Debt management is a subset of debt consolidation. Like debt consolidation, a debtor takes several credit card bills and reduces them to one monthly payment at a lower interest rate. For many debtors who have lost a job or suffered a reduced income and are trying to get back on their feet debt management may be the way to go. However, there are some considerations and consequences that a debtor has to consider before going this route,
If you are considering debt management as an option, utilize a non-profit credit counselor. To locate an agency near you, try going to the National Foundation for Consumer Credit at http://www.nfcc.org/FirstStep/locator.cfm. The NFCC member agencies have trained counselors who can do everything from counsel on housing options (reverse mortgages or foreclosures) to assistance with budgeting, credit counseling for bankruptcy purposes or offering debt management plans.
Usually, the set-up and debt management fees are very reasonable and well under $100.00. Why do you think that is? Because the non-profit credit counseling agencies receive their funding, in part, by the credit card companies! Credit card companies will work with these non-profits because the debtors are required to pay back the full amount of their debt, albeit at a lower interest rate.
Some other downsides of using this option:
(1) Debt management plans (DMPs) require that debtors stop using their credit cards completely and they cannot obtain any new credit while in the DMP.
(2) While the debtor is in a DMP, that fact will be reported on the debtor’s credit. When the debtor completes the plan, the reporting will cease.
(3) There is no requirement that a particular creditor agree to a DMP. Many do, but there is no requirement.
(4) If a debtor misses a payment, the debtor may find him or herself back where he/she started and owing as much as before. Even worse, the DMP may have guidelines and not accept the debtor back into the plan.
(5) The payments requested by the credit counseling agency are just too high to make the plan affordable.
(6) Because the credit counseling agencies are funded by the credit card companies, they only work with original creditors. For debts that are seriously delinquent and have moved on to collection agencies, credit counseling will not help.
Debt resolution, also known as debt settlement or debt negotiation conjures up many negative connotations. In fact, many attorneys who post on various legal advice sites frequently mention scam in the same sentence as debt settlement. And they would not be far from wrong as there are many bad actors that prey upon those who are already in need of help and unbelievably make a bad situation worse. So a debtor who is considering this option needs to do some homework first and thoroughly check out a debt settlement company before forking over thousands of dollars and falling for empty promises.
With debt resolution, the debtor offers to settle a particular debt for less than the balance owed. When the debtor decides to go this route, the debtor starts putting aside funds into a special purpose dedicated account in the debtor’s name. When the debtor accumulates enough funds in the account (say 50% of whatever the balance is on a particular debt), the creditor or collection agency is contacted and hopefully the debt is resolved. The particular percentage will vary, but usually the debtor comes out financially ahead by paying back less than 100% of the debt. The debtor then goes about replenishing the funds in the special account and the next debt is settled when the debtor again accumulates sufficient funds.
There are both pros and cons with this options. First the pros:
(1) The debtor’s participation in debt settlement is not reported to any credit bureaus.
(2) The debtor, if he or she diligently saves funds, can resolve unsecured (credit cards or personal loans) for far less, even including any fees paid to a debt settlement company and any taxes, than if the debtor repaid every penny borrowed, plus interest and late fees.
(3) The debtor can become debt free in a relatively short period of time rather than be a debt slave for a much longer time by paying only the monthly minimums.
(4) Resolving debts takes negative information by turning it into more positive information on a debtor’s credit report. By this I mean that where a credit report showed delinquencies or charge offs, settled debts will be reported as “paid debt settled” or “paid collection” to the credit bureaus. The resolution of the debts from unpaid to paid debts helps create a more positive credit picture to lenders. Of course, only the passage of time and the responsible use of credit going forward can truly heal damaged credit.
Now the cons:
(1) While the debtor is free to decide what debts to settle, the fact is the debtor will find it difficult to obtain any new credit. If a debtor is considering refinancing an existing home or obtaining a home or car loan, then the debtor needs to do that before entering into any type of debt program.
(2) A debt settlement company should not tell a debtor to stop paying his/her debts. However, as a practical matter, the debtor finds him or herself in a bad position. The debtor has too many debts and not enough income. In a battle or emergency where many people are hurt, all will be treated but priority has to be given to the most seriously wounded and they get treated first. Debt resolution is no different. There is only so much money to go around and things like cars and mortgages and daily living expenses should be accorded priority over credit card debts. However, when the debtor does stop paying his/her credit card bills, the debtor’s credit score is going to take a nosedive.
(3) In order to settle or negotiate a debt, it is a fact of life that creditors will seldom agree to resolve a debt for a fraction of what is owed unless a debtor is behind by ninety (90) days or more. By then, a debtor’s credit is ruined. And a debtor’s credit report will continue to have the adverse information until the debt is resolved or becomes stale.
(4) Cost. Like anything else, services by a debt settlement company costs money. Depending on the policies of the organization, debt settlement companies may charge up-front fees before performing any work on a debtor’s behalf. The Telemarketing Sales Rule (TSR) was designed to eliminate some of the bad behavior by prohibiting debt settlement companies from charging a fee for transactions done on the phone until a debtor makes at least one payment under a settlement. There are exceptions to this rule (such as an exception for lawyers or for companies that meet with a client face-to-face). While a TSR client will accumulate funds on a faster basis, the fees still have to be paid.
(5) Tax consequences. Under the tax laws, the IRS requires that forgiven debt which exceeds $600.00 must be reported. Therefore, a credit card company which agrees to settle a debt for a fraction will report the forgiven amount to the IRS and send the debtor a 1099c (cancellation of debt). The debtor will then have to include the forgiven amount of the debt in his/her income. Whether a debtor will have to actually pay tax on that amount is beyond the scope of this article (see my article on cancellation of debts at http://www.rachelhunterlaw.com/articles/article_7_Cancellation_of_Debts_AND_1099cForms.html). Suffice it to say that a debtor who receives a 1099c should talk with his/her tax preparer and see if all or some of the forgiven debt can be excluded.
(6) Notwithstanding any promises to the contrary, I am not aware of any debt settlement program out there which prohibits a debtor from being sued. The fact is that while the debtor is building up funds, his/her creditors who are impatient can and will sue. Lawsuits certainly can be managed but promises that a debtor will not be sued are wholly unrealistic.
In sum, these are all the different ways of dealing with a situation in which debts exceed income. You should be leery of companies that promise an easy and painless way out of debt. There is no magic wand or pill. Each of the methods has good and bad points. What is right in each case depends on the debtor’s age, circumstances, assets and debts, so what is right for one person will not work for another. It helps to have the situation reviewed by an attorney who focuses on this area of the law or by a certified credit counselor/debt analyst who will assist you in making the best choice.
Copyright (c) 2012 by Rachel Lea Hunter
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