When drowning in debt, many people who fear filing for bankruptcy protection seek out alternative solutions to address the problem. These alternatives are often presented as being more reasonable than bankruptcy, doing less damage to one’s credit score and resolving debts without the stigma of a bankruptcy filing. They hope that these promises are kept and that these other options will fix their financial problems without the long-term consequences of bankruptcy.
The truth, however, is that most of these alternatives do not work the way that they are presented. Many of them actually end up creating more problems for the person seeking help, leaving them further in debt and with fewer options than they previously had, after spending significant amount of money on the program. Let’s review the most common alternatives to bankruptcy, discuss how they work and the risks associated with each one.
Maintaining the Status Quo
One of the most common “alternatives” to filing for bankruptcy protection is to simply continue juggling payments and hope that the situation gets better. People will alternate bills to pay, pay less than the minimum amounts due and skip months when necessary, all the while hoping that a solution will present itself in the future. They avoid answering the phone or opening mail to avoid collection actions and just continue to struggle.
Using this method usually just prolongs the inevitable bankruptcy filing, but not until the person has needlessly spent hundreds or thousands of dollars trying to juggle debts that will never realistically be paid off. Debt balances continue to increase, with interest and late fees piling up. Eventually creditors will seek to garnish wages, freeze bank accounts and intercept tax refunds, further complicating an already bad situation.
While fighting to work through financial challenges is admirable, one must realize when the situation has gotten out of hand and seek the advice of a professional.
Debt Management Plans
A proper debt management plan is usually structured through a non-profit credit counseling agency. The agency requires the person to make a single monthly payment to them instead of paying the debts that are included in the plan directly. The agency then is to negotiate with the creditors individually to reduce payments, interest rates, late fees and sometimes balances. They collect the monthly payments and distributes the funds to the creditors based on what they were able to negotiate.
When a debt management plan is run by an proper agency, they can be successful for people with steady and reliable income, modest debt levels and no pending legal actions against them. Many, however, do fail. Creditors are often not willing to make significant concessions in negotiations, there are too many creditors involved, and the plans are simply unaffordable for the individual seeking help. Even worse, if an unexpected expense arises and the person cannot make a payment or two, the creditors cancel the negotiated agreements, reinstate all of the fees and put the person into a worse position than when they started.
Debt Consolidation Loans
Many lenders, both reputable and not as reputable, offer debt consolidation loans. The premise is simple, the person in debt takes out a single new loan and pays off all of their outstanding credit cards, medical bills, payday loans, etc. The idea is that this single monthly payment, sometimes with better terms and lower interest rates, will be easier for the person to manage. Debt consolidation loans feel like a very responsible action, promising to simplify a person’s financial situation and save money while paying off the outstanding debts.
In reality, debt consolidation loans generally fail over the long-term. The root cause of the person’s problem is usually that they do not have enough income to pay their debts, not that they cannot juggle payments. Consolidating the debt into one payment that the person cannot afford does not solve the problem. Additionally, the person is still usually living paycheck to paycheck after taking on the consolidation loan. Then, when another unexpected expense arises, they use their now zero balance credit cards to pay for the expense, driving them deeper into debt. Within a year or two, many people who try a consolidation loan are in a worse financial position than when they started.
Debt Settlement Plans
There are a lot of debt settlement companies that spend a lot of marketing dollars trying to lure in the unsuspecting consumer with debt into their programs. They promise to negotiate a settlement with the person’s creditors, reducing balances owed and eliminating all interest and late fees. Their programs sound great. Instead of paying creditors, you make payments to the company every month. The company saves the money until they have enough to make a “lump sum” settlement with each of the creditors, often promising that this will be less than half of what is owed to them. As each debt is settled, you become debt free.
Debt settlement is one of the riskiest and most dangerous alternatives to bankruptcy for multiple reasons. First, as soon as you stop paying your creditors, late fees, penalties and over-the-limit fees start piling up, driving up the amount you owe rather than down. Second, the creditors are not required to accept settlements or stop any collection actions. Some may, but others may refuse and take legal action against you. Once the first wage garnishment hits, you will be unable to pay the debt settlement company and the entire plan fails. Three, debt settlement companies usually charge significant fees, often 20 – 25% of your total debt, and they collect their share before trying to negotiate settlement with any of your creditors. Too many people pay on these plans for months and months, then are forced to stop, only to learn that the debt settlement company has kept all of their payments for themselves while allowing the debts to increase and credit score plummet for the person in the program. Finally, even a successful debt settlement plan will take, on average, two to four years to complete (during which creditor harassment is constant). This is roughly the amount of time it will take your credit to recover from a bankruptcy filing, except at the end of the debt settlement plan, your credit score remains low.
Many people who attempt debt settlement end up much worse off. Their credit is ruined, they are still facing collection efforts including lawsuits and they have lost thousands in fees paid to the debt settlement company. They often end up filing for bankruptcy at the end of this process, when doing so initially would have saved them a lot of money and provided them with the fresh start they needed initially.
Using Retirement Accounts or Home Equity to Pay Debt
All too often a client would come into my office, still in financial trouble, but after they had taken an action that I would have advised them against. Usually that action was borrowing from their retirement account, withdrawing from their retirement account or borrowing against the equity in their home to pay down their debt. The thought process makes sense, using an existing asset to pay off debt. Usually, however, this is not a good plan of action.
Qualified retirement accounts like a 401(k), 403(b), pension and most IRAs are 100% exempt in bankruptcy, meaning that they are completely protected and cannot be lost. Early withdrawal from these accounts not only depletes the protected asset, but subjects the person to significant taxes, penalties and fees, further depleting these accounts. It is basically sacrificing future security to pay debt today. Similarly, borrowing against these accounts moves the debt from multiple unmanageable payments to a single unmanageable payment, one with more severe repercussions of nonpayment. If a loan against retirement funds is not timely repaid, then it is treated as a withdrawal, with all of the associated taxes, penalties and fees.
Home equity, built over many years, is again often able to be protected in a bankruptcy filing. Once the debt is incurred against the home, however, it has to be paid off in accordance with the terms of the agreement in order to keep the home protected. The process, again sound in theory, simply converts unsecured debts with limited collection rights into a secured debt that can foreclose on your home.
Lastly, and this is a painful reminder, too many people use their retirement assets or home equity to pay off their debts, only to start using their credit cards and lines of credit again and getting into even worse shape. Now, they are not do they have fewer net assets, but they have even more debt than before.
Borrowing from Family or Friends
This is a landmine for people in debt, as they try to borrow from their family and friends to help them find their way out of debt. They feel safer trying to do this, as there is no credit check, no paperwork and an inherent trust that the debt will be paid back.
Unfortunately, money changes relationships, particularly money owed. If the person who borrowed cannot repay the funds timely, resentment and guild can accumulate on both sides. Family gatherings become more tense, friends stop communicating and the person who borrowed the funds feels terrible about the situation. This is exacerbated if the lender of the funds really needs to be repaid to handle their own financial challenges and the borrower is not able to do so. Again, this action also does not fix the underlying problem, the inability of a person to pay off their debt. It simply shifts the debt from various companies with limited collection ability to friends and relatives, with likely more limited collection abilities but overall more at stake.
Payday Loans, Signature Loans and Title Loans
This, unfortunately, is a very common way for people whose finances are spiraling downward to address immediate, short-term issues, creating significant long-term problems. These types of loans are short-term by nature with huge interest rates. Payday loans often exceed 300% annually in interest. There is little paperwork involved, and the borrower gets the cash they “need” immediately. People use them to cover a specific, urgent expense with every expectation to pay them off just as quickly.
More often than not, however, the borrower is unable to pay the balance when the loan matures. These lenders are more than willing to “roll over” the loan with a new agreement and a new exorbitant interest rate. When the new loan comes to term, the borrower still cannot pay it and rolls it over again. In very little time, the few hundred dollars borrowed turns into thousands of dollars owed. If the title of a vehicle is pledged, the lender can get title to the vehicle and take it from the borrower. Often times a voluntary wage assignment is required, allowing the lender to immediately take money from the borrower’s paycheck without a court order required.
These types of loans create a vicious trap, keeping borrowers in an endless stream of increasing debts and unaffordable payments, often resulting inevitably in the bankruptcy filing that would have made much more sense at the start of the process.
Trying these alternatives to bankruptcy, usually with the best of intentions, often results in tragic consequences. Credit scores are destroyed by missed payments, late payments and defaults. Earnings and savings are lost making payments that do not effectively improve the person’s situation. Many people who attempt these alternatives ultimately end up filing for bankruptcy protection, so it is worthwhile to consult with an attorney early when financial warning signs are raised.
