When you have a lot of debt and you are having difficulties paying off your creditors, no doubt you have thought about filing for bankruptcy protection.  A recent trend in this challenging economy is the idea of debt consolidation.  If you are in such heavy debt, would you consider debt consolidation or bankruptcy protection?

What is debt consolidation?

Debt consolidation if done right is when you take out one loan to pay off all your other loans.  If you have 3 credit card, a car loan, a store credit card, when you choose to do debt consolidation, you will find a loan big enough to pay off all 5 loans.  The theory behind debt consolidation is that it is easier to manage 1 account versus managing 5 separate accounts.  If you only have to worry about 1 payment per month, you are more likely to be punctual with the payment.  Some debt consolidator even claims that they can help you reduce the balance of your debt with the creditors.

What does it mean to file for bankruptcy protection?

Bankruptcy is the legal process where you can relief yourself of certain debts because you are no longer able to pay for them.  Personal bankruptcy comes in 2 flavors, Chapter 7 bankruptcy versus Chapter 13 bankruptcy.  Chapter 7 bankruptcy allows you to remove most debts, whereas Chapter 13 setup a much reduced repayment plan of the debts that you have accumulated.

Why I would prefer bankruptcy over debt consolidation

If you already have unmanageable amount of debt, why would you want to take on the responsibility of paying off this debt, even if it is only a small percentage of the entire debt?  Why would you not consider getting rid of your debt entirely?  Let me give you a concrete example.

Let us say you owe over $50,000 in credit card debt.  In the case of debt consolidation, if the debt consolidator was able to reduce this debt with your creditors to $25,000 payable over a period of 3 years with no interest (note this is a very optimistic scenario and mostly likely will not happen).  This still means you will owe the creditors about $694 per month for 3 years.  Don’t forget you will still have to pay the debt consolidator for his/her service.  Even if this debt consolidator is only charging a flat fee of $1,000, that translate to $28 per month spread out over the period of 3 years.  So at this point you will be paying $694 + $28 = $722 per month if you opt to go with the debt consolidation method.  Here is the big kicker, you are NOT paying just $722 to settle this debt.  You are paying much more than that.

When the debt consolidator “magically” negotiated with your creditors to reduce the debt by half to just $25,000, someone still needs to “pay” for the missing $25,000.  In the eyes of the big brother Uncle Sam, our good friend the Internal Revenue Services (IRS), IRS treats this missing $25,000 as income to you.  So depending on the level of your tax bracket, you will have to pay taxes on this $25,000.  If you are in the 25% tax bracket, you will have to pay $6,250 for this additional “income” at the end of the tax year.  In the end, you are not just settling your debt for $25,000, but more like $32,250 ($25,000 + $1,000+ $6,250).

Now that you see how much you have to pay when you choose to do debt consolidation, let’s talk about the advantage of filing for bankruptcy protection.  If you can file for Chapter 7 bankruptcy protection, all of your initial $50,000 debt would have been wiped out when your bankruptcy discharge is issued.  The only expense that you have to incur is the fee for your bankruptcy lawyer, which generally runs between $1,000 – $3,000.  I don’t disagree that bankruptcy can ruin your credit for 7-10 years, but if you are already having difficulties paying off your creditors, or receiving harassing phone calls from creditors looking to get some of their money back, there is really not much difference.  Your credit history is already marred even if you do debt consolidation so why eliminate your debt in one shot with bankruptcy and not have to worry over the course of 3-5 years when you have to repay your debt.

Financially speaking, doesn’t  it just make perfect sense to file for bankruptcy protection and save yourself the money that you will be paying with debt consolidation?  Why not take the money that you are planning to repay the creditors and put it into your savings account and start to build a better and more stable financial future?

Tags: Bankruptcy, Chapter 13 Bankruptcy, Chapter 7 Bankruptcy, Debt Consolidation, File For Bankruptcy, Internal Revenue Services

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Posted in Why File Bankruptcy by ssanchez No Comments Yet