Alternative Debt-Relief Options to Bankruptcy

Learn your options for getting out from under debt.

Bankruptcy can be a useful debt management tool, but other options exist. Depending on the amount of debt you have and the status of your credit score, you might be able to take control of your financial future without filing a bankruptcy case.

Walking Away From Debt

It might not sound appealing, but walking away from bills is an option. If you choose this drastic route, you should do it with your eyes open. The option works best for people who don't anticipate having an income or property that a creditor can take in the future. Attorneys often call such individuals "judgment proof."

By contrast, this method probably isn't a good solution for someone with assets because of the steps a creditor can take to collect, which include:

  • repossessing your car
  • foreclosing on your real estate
  • filing a lawsuit against you
  • using the lawsuit judgment to seize funds in your bank account, garnish your wages (if allowed in your state), or take other types of personal or real property, and
  • report the unpaid debt to the IRS, who will treat it as income and assess taxes.

Most debts have a statute of limitations period that runs four to ten years. The statute of limitations is the state law that sets the time the creditor has to sue you and get a judgment on the debt. After the limitations deadline, the creditor can no longer file a lawsuit, but it can continue other collection efforts indefinitely, such as calling you and sending letters.

Negative information about your credit accounts will stay on your credit record for up to seven years. Many creditors will stop trying to collect at that point because they've lost all leverage.

Settling Debt

If you have some cash, you can try to negotiate with creditors to settle for less than what you owe. It's not unusual for creditors to agree to take 40 to 60%, but they'll usually want it in a lump sum.

Keep in mind that this isn't always as good of a deal as it might seem. Although you might pay less, the creditor will likely report any amount forgiven (the amount you don't pay) to the IRS. The IRS will treat the forgiven debt as income to you, which could increase the amount of income tax you'll owe the next year.

Companies that negotiate on your behalf will probably ask that you make a payment into an account each month. When the balance of your account reaches a certain level, the settlement company will use the money to settle the debt. The process continues as long as the debt remains or until you quit the process. The Federal Trade Commission has published some helpful information about dealing with debt settlement companies.

Managing Debt

An alternative to debt settlement is debt management. You can do this yourself, but you might find that working with a reputable nonprofit agency, like your local affiliate of Consumer Credit Counseling Services, will give you more leverage.

The agency will negotiate a payment plan with your creditors, often with a reduction in the interest rate or principal. You'll agree to make a monthly payment to the agency, who in turn distributes the payments to your creditors according to the plan negotiated by the agency. Your creditors agree to stop harassing you for the debt as long as you're making monthly payments.

Consolidating Debt

You'll also want to explore whether you can restructure your obligation so that you're paying less overall. Here are a few ideas.

  • Balance transfer. If your credit is still relatively good, do your research and find a credit card that offers a lower interest rate. Be mindful of special offers that reduce interest rates for a limited time and low rates offset by high fees.
  • Consolidation loan. A consolidation loan from a bank or credit union will pay off some or all credit card accounts and allow you to make one payment for a set term. A consolidation loan will only work if you close your old accounts and don't open any others until you pay off the debt you're consolidating.
  • Borrowing against assets. You might be tempted to borrow against your home or your 401k to pay off debts. Very few financial advisers, accountants, or attorneys recommend using these assets to pay the debt. If you're unable to pay a home equity loan, you risk losing your home. There are stiff penalties for withdrawing your money early from a 401k or an IRA, and you'll have to pay income tax on the amounts you withdraw and don't pay back.

Before you take such steps, it's prudent to speak with a bankruptcy attorney. The lawyer can review your debt and advise you whether assets such as your 401k, IRA, and other retirement accounts are outside the reach of creditors. Much of your home equity might also be protected, depending on where you live.

If you use those assets to pay debts or as collateral on a loan that paid those debts, you could be needlessly putting yourself in a bad situation if you need to file bankruptcy later. That's because you'll be using assets that you could keep in a bankruptcy case to pay a debt that could have been wiped out in bankruptcy.

Bankrupting Debt

When you can protect (exempt) most or all of your property in bankruptcy, and the majority of your debts qualify for discharge (forgiveness), then filing for bankruptcy might be a good choice for you. Most individuals will file one of two types:

  • Chapter 7 bankruptcy. A Chapter 7 case, also called straight bankruptcy, takes a shorter amount of time (four to six months) and is usually less expensive. In exchange for the discharge of debt, you agree to turn over all property that you cannot exempt. Every state has a list of the types of property you can protect and the maximum value of each category. Most people can keep all of their household goods, furniture, retirement savings, a car, and even some equity in a house.
  • Chapter 13 bankruptcy. Chapter 13 case works differently. You propose a debt repayment plan that includes any past due amounts on your mortgage and car loans, child support, alimony, and income taxes. Instead of turning over nonexempt property, you'll make your Chapter 13 plan payments monthly for three to five years (you'll pay the value of the nonexempt assets in the plan).

Filing for bankruptcy has advantages that none of the other options will ever offer. You have the protection of the bankruptcy court. The court has control over everything that happens in the case, and creditors cannot take action against you without court permission. Also, in both chapters, your qualifying debt gets discharged after you complete the case. As a bonus, you won't have to pay income taxes on the discharged debt.

(Read Chapter 7 vs. Chapter 13 Bankruptcy for more information about bankruptcy.)

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