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In A Nutshell

1) Bankruptcy Should Be “Option Of Last Resort”

2) Debt Is Too Large To Pay Back

3) Tax Consequences

4) Unsecured VS. Secured Debt

In More Detail


1) Bankruptcy Should Be “Option Of Last Resort”

First and foremost, I want to begin this post by stating that I treat bankruptcy as an “option of last resort.”  Bankruptcy is not something I take lightly, and neither should you. When I file a bankruptcy for a client, I always make sure that we have explored all other options to solve their debt crisis.  Bankruptcy can be hard and grueling at times (especially a Chapter 13) and needs to only be entered into if no other option will achieve the same result as a bankruptcy. I typically advertise to fill out my online intake form with iBankruptcy to “see if bankruptcy is right for you,” because it may be that bankruptcy is not right for you.

That being said, while bankruptcy might not be what you want to do, it may be what is necessary to bring you into debt freedom.  There may be no other option that can quickly and cost effectively take away the debt, collection attempts, and stress that comes along with both.  Below I will talk about some of the reasons why bankruptcy may be your best option. Explore the bankruptcy option here.


2) Debt Is Too Large To Pay Back

Obviously one of the best alternatives to filing a bankruptcy is to pay back the debt that you owe.  This is often easier said than done. To limit the amount of debt that you have to pay back, you may explore options that involve settling your debts or consolidating your debts into one monthly debt payment with a lower interest rate.  Both options may be worth exploring, but if your debt is too high then it may be something that will end up costing you more money than you expect.

Debt Settlement.  Debt settlement can be done if you are willing and able to reach out to all of your creditors and negotiate the amount of debt you will pay back.  Most of the time, debt settlement results in you hiring a company specializing in negotiating the balance owed on individual’s debts. You begin this process by entering into a payment plan with the debt settlement company.  Once you reach a certain plateau of money in your account, the debt settlement company will begin to settle your debts. Keep in mind 2 things: (1) the debt settlement company has to get paid through your monthly payments as well; and (2) while you are paying the debt settlement company you are not paying your creditors which leads to a negative affect on your credit score and likely continued collection efforts against you. 

An issue with debt settlement can arise if you have too much debt to settle.  If you use your available funds or liquidate your assets to settle 3 debts but still have 2 remaining with nothing left to pay them, then what good has settling your debts been?  You could still be forced to file bankruptcy to eliminate the debt that remains after spending all of your money on the settled debt.

For example: you have 3 credit cards (totaling $50,000) and 2 personal loans (totaling $40,000).  Because the interest rates on the credit cards are higher, you choose to work with a debt settlement company to settle them.  For 2 years you pay $1,500 per month to the debt settlement company which settles the credit card debts. Paying this high monthly payment has forced you to liquidate your 401(k) and forgo any payment to the personal loans.  You attempt to settle the personal loans (which now have a balance of nearly $50,000 because of interest and late fees) but are unable to afford another 2 years of paying $1,500/mo. The creditors’ collection efforts become too much to bear, forcing you to file bankruptcy to stop them and discharge the debt.  You have now paid $36,000 to pay off your credit cards and still have to file bankruptcy to discharge your remaining debt. 

Debt Consolidation.  Debt consolidation involves you taking all of your debt and combining them into one, large debt.  Often this technique can be used to lower the interest rate on your debt and lower the total monthly amount you are paying on your debts.  Practically, debt consolidation requires you to take out one big loan to pay off all of your smaller debts.

An issue can arise if you have a very large sum of debt that leads to a large monthly payment through debt consolidation that you may not be able to afford for the entire length of new debt repayment agreement.  Also, while it can work in certain circumstances, I am often not a fan of using the equity in your home to incur debt to payoff your credit cards and personal loans. By doing this, you are turning unsecured debt into secured debt.  The secured debt is attached to your home and the result of not paying the new debt is the creditor foreclosing on your home.  

Example Of Good Debt Consolidation.  You have 5 credit cards with a total balance owed of $25,000.  The interest rates on the cards vary from 20%-30%, and your total monthly payment equal $2,000 which barely touch the principal balance.  You decide to take out a personal loan for $25,000, pay off the credit cards, and begin paying 1 creditor instead of 5. The new loan agreement has a fixed interest rate of 10%, is for a 5 year term, and has a monthly payment of approximately $530.  

Example Of Bad Debt Consolidation.  You have 5 credit cards with a total balance owed of $50,000 with interest rates varying from 20%-30%.  Your total monthly payments are $3,000. You have $50,000 of equity in your home and decide to take out an equity line to pay off the credit cards.  The equity line is required to be paid back in 5 years at 7%. This equates to a monthly payment of $990. You decide during the 5 year period that you want to retire (or you are forced into retirement because your company is downsizing or you become unable to work).  You now are unable to pay the $990 monthly payment, causing your house to be in jeopardy of foreclosure. 


3) Tax Consequences

There can be unexpected consequences that result from settling your debts with creditors. One of the most unfortunate consequences is the tax liability that may result.  You may settle the debt with the creditor, but because of the IRS rules, you may then owe taxes on the money you did not pay to the creditor. One key point: If you settle a debt, then save more money than the settled upon amount in order to pay the IRS for the resulting tax liability.

If any debt that you owe is written off by a creditor, then the IRS treats this as taxable income for you.  You are required to report this write off as income on your tax return and pay the appropriate tax that results.  A creditor is required to actually report any write off of $600 or more to the IRS (via IRS form 1099-C). So, the IRS will know of larger write offs and force you to include the amount as income on your tax return.

A “write off” is what occurs when a creditor settles a debt for less than what you owe.  The amount you owe but do not pay is taken as a loss by the creditor. To minimize the loss, the creditor is able to receive some tax benefits by writing off the debt.  The tax burden for the amount written off shifts to you.   

For example:  you owe $10,000 on a credit card.  You and the creditor agree to settle the debt for $6,000.  The creditor writes off and reports to the IRS the remaining $4,000.  Because of your employment income you fall in the 25% tax bracket, forcing you to pay $1,000 (25% of $4,000) in taxes on the written off debt. 

No Tax Consequences In Bankruptcy.  When you successfully complete a bankruptcy you receive a discharge wiping away your debt.  Because a creditor you once owed has their debt wiped away, the creditor may write off the debt.  They may even report the written off amount to the IRS. But, your bankruptcy discharge will save you from having to pay any taxes on the written off debt.  If you receive a 1099-C for a written off debt following your bankruptcy, then you will want to talk to your accountant about the proper IRS form that needs to be filed with your tax return. 

For example:  you owe $10,000 on a credit card.  You file a Chapter 7 bankruptcy and receive a discharge.  The creditor writes off the $10,000 balance. Because you filed bankruptcy you do not have to pay any tax resulting from this write off.  


4) Unsecured VS. Secured Debt

One other factor to consider when determining whether to enter into a debt settlement agreement, debt consolidation, or bankruptcy to deal with your debt crisis is the type of debt you have.  Debts are generally broken down into 2 categories: unsecured and secured. Having one type of debt or the other may limit the options you have in dealing with those debts.  

First let me define unsecured and secured debts.  

Unsecured debts are those where there is no collateral acting as security for the debt.  The borrower (you) simply agrees to pay back the debt owed. The typical unsecured debts that individuals incur are credit cards, personal loans, and medical bills.  The result of not paying an unsecured debt is that action is taken against you to “encourage” you to pay. These collection efforts often take the form of collection calls, collection letters, and lawsuits. 

Secured debts are those which the borrower (you) pledges an asset you own as collateral for the money that is loaned.  The most common secured debts are a mortgage (secured by real estate) and vehicle loan (obviously secured by a vehicle).  The result of not paying a secured debt is that the asset used as collateral is taken by the creditor. This is often seen through foreclosures of people’s homes or repossessions of their vehicles.  

Now let’s talk about how the type of debt you owe may affect your decision on how to eliminate the debt.

Debt settlement is really only an option if you have unsecured debt.  If you reach out to a 3rd party company to assist you in the settlement of your debts, then they will let you know that they can only assist you with the unsecured debts.  A creditor of a secured debt is more protected against your inability to pay because of the collateral. A secured creditor is much less likely to agree to receive a reduced amount due to the fact that they can repossess or foreclose on the collateral to satisfy (or come close to satisfying) the debt owed.  If your trouble is caused by secured debt, then you will want to look somewhere other than debt settlement to solve your issue.

Debt consolidation can be a method used to resolve issues you have with unsecured debts and possibly small secured debts.  I spoke above about how debt consolidation works, but again quickly, you take out a large loan to pay off smaller debts. You could use this technique to pay off credit cards, medical bills, and possibly your car.  This could make sense if your car loan has a very high interest rate and the new loan will be at a reduced rate. But, debt consolidation will not assist you if your issue lies with larger secured debts where you are unable to take out an unsecured loan large enough to pay them off (remember that I am not typically a fan of taking out a secured loan to consolidate your debts).  For example, if you are behind on your mortgage and owe $100,000, then it is unlikely that you will be able to get an unsecured loan to pay off this large amount. You will need to try to modify your current mortgage or look to bankruptcy.  

Bankruptcy may be your best option to deal with all of your debts.  It appropriately handles unsecured and secured debts and puts you on a path where you can see the light at the end of your debt tunnel.  Complete our online intake form to see if it is a good option for you. 


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