Before filing for bankruptcy, it is wise for debtors to attempt to negotiate with their creditors either directly or via a third party. Particularly since the onset of the current financial crisis, creditors have become more willing to work with debtors to get some repayment, rather than risking that the debtor will file bankruptcy, causing them to get no repayment at all. Though bankruptcy attorneys have been engaged in this type of negotiation for years, a whole cottage industry has sprung up around the concepts of debt settlement and debt consolidation.
Debt settlement programs typically involve a third party negotiating with a debtor’s creditor in an attempt to get the creditor to allow the debtor to pay a lump sum that is less than the full amount owed. If the settlement offer is accepted, the creditor will consider the debt paid.
While there are many not-for-profits, reputable attorneys, and other legitimate businesses negotiating debt settlements, there are also a lot of scam artists looking to take advantage of desperate debtors. Debtors should make sure they understand what fees, if any, the negotiator charges for the services, and be wary of any adviser who suggests the debtor stop making payments to the creditor before a settlement is reached.
Debtors should also be made aware that debt reduction may be taxable as income. Not knowing that the IRS treats forgiven debt as income can come as quite the shock at tax time, leading to further financial troubles.
Debt consolidation is exactly what it sounds like. A debtor takes out a new loan to pay off other loans, reducing the number of creditors and payments the debtor must keep track of. In addition to simplifying the debtor’s finances, the new loan often has a lower interest rate.
While a lower interest rate sounds like a great deal, debtors should carefully analyze the long-term costs involved. Lower interest rates and/or lower monthly payments often come in exchange for extending the loan period. A lower interest rate for a longer period of time can cost more than a higher rate for a short period of time.
The fees charged for consolidation should also be carefully investigated. The fees (and in some cases penalties) charged by consolidation companies and by the creditors can end up costing more than the consolidation saves.
In order to get the new loan, the borrower will typically have to prove that he or she has some sort of collateral that the new creditor can claim if the borrower defaults on the loan. If the borrower is not confident he or she will be able to make the payments on the new loan, consolidation puts assets that might otherwise be untouchable by creditors at risk.
It is wise to consult with an experienced attorney before entering into a debt settlement or consolidation agreement.