Bankruptcy Versus Debt Settlement

Video: My Thoughts on Debt Settlement

Here is an email question I received the other day:

Patrick, I attended your class last year and have purchased your book. I have a client who has about $70,000 in credit card debt.  They are planning to file bankruptcy but don't want to lose their home or their retirement accounts.  I suggested they use a non-profit credit association company to work out a payment plan and pay their debt.  I don't want to lead them down the wrong path as I am not a financial advisor.  You implied in your book and class that bankruptcy might be the best route for their credit.

What is your suggestion?

There are many things they should consider, here is my short list off the top of my head:

• They likely can keep their retirement accounts in a bankruptcy; the statutes in most states give retirement accounts an exemption from creditors. The list of exemptions will be in your state codes/statutes, the legislative websites have great search features for locating the information. Or check with a bankruptcy attorney, Stephen Trezza is a knowledgeable bankruptcy attorney with useful information on his website: http://www.filebankruptcyinarizona.com/Chapter-7-Bankruptcy/What-Can-I-Keep-After-Filing-Chapter-7.shtml

• As long as they continue to make the payments they can most likely keep the house. This decision needs to be weighed carefully, do they really want to keep the house, can they afford it?

• People who go through bankruptcy will generally have better credit within 2 - 3 years, whereas people in credit counseling repayment programs can be in bad credit shape for 3 – 5 years.

• Through bankruptcy (Chapter 7) they may be able to discharge the entire $70,000 balance, depending on if they qualify based on their income

• A bankruptcy is a permanent public record, but falls off the credit report within 10 years, they could buy a house again within two years of a Chapter 7 bankruptcy

• Credit counseling is not part of the permanent public record and will fall off the credit report in 7 years generally (this is the way to go if they have political aspirations). There are circumstances where it makes sense to go through CCC instead of bankruptcy, generally for smaller amounts; $70,000 is not a small amount.

• A major consideration is tax consequence when it comes to debt settlement, if they owe $70,000 in credit card debt and settle for half, they are possibly going to be taxed for $35,000, depending on their tax bracket this could be a shock. An important thing for consumers to realize is that even if they do not qualify for a Chapter 7 discharge, going the Chapter 13 route may turn out better than settling through a non-profit. For example, let’s say the non-profit gets the creditors to settle for half, but the court may order that the creditors will receive ten cents on the dollar. Bankruptcy can be superior even from a settlement standpoint.

• With debt settlement through CCC the consumer does not lose any assets (other than the money they are paying), with a Chapter 7 bankruptcy the debtor would lose any non-exempt assets (personal property, stocks, savings, etc.). In a bankruptcy the non-exempt assets are auctioned off, I go to these auctions frequently. Many times the debtors will go to the auction and bid on their own stuff, which is allowed. Last year I purchased $2,300 worth of framed art for $80, the assets were from an art gallery that went under. The possibility of losing personal property is a major factor in making the decision to go the bankruptcy route, especially if the debtor has cherished keepsakes that would have to go to auction to pay creditors. It is a good idea to sit down with an experienced bankruptcy attorney for an exemption planning session to plan out the bankruptcy thoroughly.

If given the choice between a payment plan and discharging the debt it is almost always a better idea to discharge the debt. At the point of discharge the credit begins to heal, whereas with a repayment plan the damage continues until the account is settled and closed out. It is also important to realize that there are specific laws and procedures for bankruptcy, plus there is oversight. In the world of credit counseling there is no schooling, there is no licensing, there is no bar exam to ensure proficiency, it is a wide open wild west of sorts. I do believe there is a place for credit counseling, as long as the organization sticks to budgeting and interpreting the credit report. An excellent measure of whether a credit counseling agency is trustworthy is if they are HUD approved. I have worked with HUD approved counseling agencies for a number of years and have found NeighborWorks organizations to be the best all around.

As soon as credit counseling crosses into a repayment plan this is where I start to feel shivers up my spine. There is a thing called the sharing rule, which allows a debt settlement/credit counseling company to receive a commission/cut of the amount they can get the consumer to pay to the creditor. I feel this is an outrageous breach of fiduciary duty at the highest level. My second major issue is that many consumers drop out of the repayment program and file for bankruptcy ultimately any way.

This is just some food for thought, being in a position of choosing between bankruptcy and debt settlement is not an easy position to be in. Given the circumstances I think they should consult with a bankruptcy attorney to inquire about their eligibility. I feel strongly about this because I see many credit reports where if someone had just filed bankruptcy they would be fine today, but instead they dabbled with settlement and it prolonged the damage.

Have a mortgage or credit question you would like for me to cover on this blog? Shoot me an email so I can address it. If you want to apply for a mortgage in Arizona give me a call at 480-203-4641, the application process is easy, and it only takes 10 minutes for me to get the information to get you started on your way to home ownership.

Patrick Ritchie
Mortgage Finance Instructor

Ritchie School of Real Estate Finance

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Patrick@PatrickRitchie.com

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