Does credit counseling, debt settlement, and bankruptcy help? And how do they affect credit?

Consumers tend to seek out options when they are struggling to make minimum payments, have a loss of income, financial stress relating to divorce, health issues, overwhelming medical bills, harassment from debt collectors, or are elderly and on a fixed income.

Credit Counseling (CC) offering debt management programs (DMP) are given by non-profit organizations that work directly with the creditors to reduce interest rates on debt. This can both increase or shorten the length of time debt will be paid off by consumers depending on the plan. These companies can evaluate your financial situation, create a budget plan, and negotiate the terms of your debts with creditors.

DMP programs will consolidate all of your unsecured debts into one monthly deposit that will be distributed to your creditors. DMP can have a devastating affect on credit scores especially if consumers have an excellent credit rating prior to starting the program since many of these organizations make payments late causing derogatory updates on credit. It may also be posted on credit that “consumer in partial payment agreement or arrangement”. Consumers who just want to save money but have excellent credit must be very cautious about involvement in this program since they will most likely lose their excellent credit rating, which could cost much more than the savings the CC provided.

Debt Settlement (DS) is a program that consumers can use to save a substantial amount of debt owed. By negotiating a smaller payoff as full settlement on the accounts debt settlement experts can save consumers hundreds and thousands of dollars depending on the individual situation. Many debt settlement companies ask the consumer to save funds in a dedicated account for payment once settlement is reached. The fee for this service may be a percentage of what was saved or a fee per account. Once the debt is settled and paid, the IRS expects consumers to pay income tax on the savings. Consumers will receive a tax form from the creditor at the end of the year. It is important for consumers to understand if they saved $30,000 that will be added to their income at the end of the year and taxed as such.

Debt settlement will devastate credit if it is in an excellent rating status and if consumers have short term financing needs like college funding they need to evaluate the success of reaching this goal before choosing this option. DS has become a very popular and lucrative business since the economy changed; therefore, there is a high level of aggressive and competitor selling going on. I am sure we have all had phone calls and messages left on our cell or home phones from telemarketers spewing the benefits of lowering debt through debt settlement. Rarely do we hear about the devastation it causes to credit.

Bankruptcy (BK) is another option for consumers with high debt, limited savings, low income or ability to earn. For many that enter into Credit Counseling or Debt Settlement their credit will be devastated anyway so a BK may very well be the least expensive best option. If a consumer is approved for a Chapter 7 BK they will include all their debt and no longer owe any money to the creditors. They will not have to pay taxes on the debt released in the BK. Of course their credit scores will be dramatically reduced. The public record of the filing and discharge of personal bankruptcies stays on credit reports for ten years.

Consumers also get confused and think filing for bankruptcy means all their debt will be erased off the credit report and only the public record will show on their reports. This is a misconception as each account included in the bankruptcy stays on the reports for seven years and the actual public record of the BK remains for 10 years.

Many consumers get involved in these programs without evaluating:

1. The affect the program will have on credit and scores.
2. All options they have before making a choice.
3. Using the current condition of their credit when making their decision.
4. Their choice with an expert prior to taking action.

Here is an example:

Susan was a high earning executive until the economy changed and her six figure annual income reduced down to $60,000 a year. She has sustained herself by working three lower paying part time positions of which one pays in cash. It took her a while to accept her inability to gain a six figure salary. In the interim, she ran through all of her savings and racked up $40,000 in credit card debt to keep her afloat. After figuring out how to get and manage these three positions she found herself struggling to pay the minimums on her credit card debt even with help from her elderly parents. Susan’s current interest on her credit card debt averages about 20%. If Susan continues on this path it will take her almost 30 years to pay off the debt and she will pay a whopping $49,352 just in interest! Clearly she must make a change. Susan would not even consider a BK since she felt it was morally wrong and would be a black mark against her for the rest of her life.

Let’s take a look at her options:

A. If she went to a CC company and was placed into a DMP her interest rate would most likely be reduced to 8% and her monthly payment would be 2% of the full debt, giving her an $800 a month payment. Susan would pay about $10,000 in interest and it would take a term of almost 5 years to pay the full debt off. Susan would pay less than $50,000 in total with this option.

B. To go into a debt settlement plan Susan would need to have a lump sum of at least 40%. The fee for the debt settlement company would be 15% of savings or a flat fee. We will use 15% of savings for this example. If Susan did not have the funds available she would either pay into a dedicated account, used by the debt settlement company, or wait until she saved the funds to hire the DS firm. If Susan has a 40% savings success she would pay her creditors back $16,000 and the debt settlement invoice would equal an additional $3600. Her total cost would be $19,600, but remember it may have taken her 4 plus years to save the money to begin this program. Whatever funds she saved with her creditors would be added on as income at the end of the year and taxed accordingly by the IRS. She must add on the cost of the tax as well.

C. If Susan qualified for a Chapter 7 BK she would pay somewhere between $1200 to $2500 and she would be released from all responsibility to pay back her debt. Student loan debt and tax debt may not qualify for inclusion in a BK, check with an attorney. Susan will qualify for a mortgage within 4 years (check with a banker since waiting period changes) and can get some credit cards immediately after. The public record of the BK would remain on credit for 10 years and each individual account included in the BK would remain for 7 years from the date of discharge.

All of these options would cause poor scores. After reviewing these choices if Susan had extreme slow payments (more than 2) on many of her credit accounts her credit scores would be poor before choosing one of these options anyway. The BK would save her the most money ($37,500) and would give her the quickest turn around, within 4 years she would be able to get a mortgage. It would take about 4-5 years for her credit to become average again if she put effort into rebuilding it and with credit repair 2 years sooner. The other two options would leave Susan with poor credit after many years of paying back tens of thousands of dollars. Once the debt is paid she will have to deal with the devastation of her credit. It could take an additional 4-5 years to build her credit back or she may have to pay an additional fee for credit restoration.

When it comes to the credit scores the difference between CC, DS, & BK credit score reductions may not be significant when you compare them all side by side. For example, if the CC Fico score reduction brings the score to a 610 Fico, the DS score becomes a 590, and the BK score ends up being a 570, what will the 40 point difference do to help the consumer? Not much since at all the score levels above, most creditors will generate a rejection for lines, loans, and better credit cards.

Contact one of our credit experts for more information!