How Debt Consolidation Can Affect Your Bankruptcy Case?

Published On: December 7, 2022Views: 1145

What Is Debt Consolidation?

Debt consolidation means having one payment for covering all your debts, and sometimes people take out a home equity loan, so they make that one payment, and then, they pay off their consumer debt.

There are other kinds of loans. When you apply for a personal loan, they’ll ask what is this for, and debt consolidation is usually one of those options.

There are debt consolidation firms, there are companies where you pay the company a certain amount every month. They have the formula to calculate what that amount would be and they settle your debt.

Find Out More About The Advantages And Disadvantages Of Doing Debt Consolidation

How Common Is Debt Consolidation When People File For Bankruptcy?

At Lincoln-Goldfinch Law Firm, we see it more than we would like to. One of our office jokes is that we are the last phone call that anybody wants to make.

People will try anything to avoid bankruptcy, and it’s seen a lot of people trying out a debt consolidation solution, which is not exactly a solution, and when that falls through and they’re facing some other kind of consequence of crushing debt, then they call us, we’re the last call that people make.

It would be better for them to call us more proactively but we see a lot of debt consolidation showing up when they call us.

Debt Consolidation’s Pros & Cons 

One of the things that makes a debt consolidation attractive to people is that it just simplifies things. You can just send one payment to this company that’s promising to settle your debt for you.

It feels okay because someone else is handling it, the individual is making their 300-a-week payment, and then, they’re gonna take care of everything. You can think about the simplicity of it and the immediacy of it feels pretty good to people.

There are a few cons that we always want to warn people about when we’re talking about these debt consolidation firms. 

What they’re doing is they will take the money they pay themselves first, then they have this pot of your money sitting in a trust account, and once your consumer accounts have gone into collections, they negotiate with those collection agencies.

Sometimes they negotiate with the original lender to say: Well, why don’t we settle this for 70 cents on the dollar or whatever it happens to be, and then, they pay because they have this lump sum sitting there.

They’re able to pay that in a lump sum, which is attractive to the lenders. The problem with that is that there is nothing in the world saying that you have to pay somebody else to do that.

If you want to settle a debt, and we advise people to do this regularly, if they’re very averse to bankruptcy, you can do that, just set aside the money, wait until it goes into collections, and then, offer to settle it for pennies on the dollar.

It happens all the time, and you do not need to pay somebody else to do that.

Another warning sign that we find troublesome, is that people might not be aware that when they settle their debt, the amount that was forgiven can get taxed as income.

Let’s say that you have a ten thousand dollar credit card debt and you settle it for six thousand dollars, so you’re wiping out four thousand dollars of that debt, which feels good.

 However, come tax time you are going to get a form that says that you are going to be taxed on those four thousand dollars that were forgiven.

That does not happen in a bankruptcy case, it’s not allowed to happen but when you settle your debt again.

The final warning is that during those negotiations with the debt consolidation firm, the debt holder (the creditor) is under no obligation to stop other forms of collective action.

Even before anything has been settled, they might be saying that they’re negotiating, but they can still go to court and try to collect from you by getting a judgment against you.

There’s nothing precluding them from other kinds of collection, you’re not nearly as protected when you pursue debt consolidation as you are in bankruptcy.

What’s The Difference Between Bankruptcy & Debt Consolidation?

Decide Whether To Work On A Debt Consolidation Or A Chapter Of Bankruptcy

In bankruptcy one of the main differences is that you have a more global kind of protection, the creditors by law are forbidden from taxing that forgiven income.

They’re forbidden from pursuing other collection activities during or after the discharge during the bankruptcy or after bankruptcy.

Often when you file bankruptcy it’s a flat fee upfront if it’s a Chapter 7 and that’s it.

The other huge difference is that in debt consolidation creditors can choose not to participate, they can just say: No, thank you. We’re going to stay outside of this agreement and we’re going to do what we want to do.

In a bankruptcy case, there is no salad bar pick and choose of what you want to include in the bankruptcy, you list all your creditors, so everybody gets included.

You pay your flat fee upfront and then you’re done with that debt.

Would Debt Consolidation Be More Advantageous Than Bankruptcy? 

We don’t think it’s more advantageous but we can understand that people think of bankruptcy as just the worst thing on the planet, a financial death sentence.

Bankruptcy is just a financial tool like debt consolidation as a financial tool.

People have this thing in their head that there’s something super bad about bankruptcy but it actually can serve you better than a debt consolidation can.

How Does Bankruptcy Affect Debt Consolidation?

Bankruptcy replaces debt consolidation, which we see when people have done a debt consolidation, especially if they’ve contracted with a company to do that.

The way that we need to treat that in bankruptcy is if that company is still holding on to some of your money they haven’t distributed to the creditors. That’s an asset that you’re entitled to get back.

That belongs to you as long as you have enough exemptions and enough protection of your property.

You should be able to get that back if they have a certain amount sitting in trust, and they know that it completely replaces it.

You will still list all of the creditors that were included in that debt consolidation plan, and then, it just erases that debt, it just takes care of that debt and you won’t get taxed on it.

Why Is Debt Consolidation So Annoying To Deal With When You File For Bankruptcy?

It is not annoying per se, it’s another step. Now, we have another company that we need to deal with to try to get your money, that’s being Held In Trust. We need to work on trying to get that back for you.

What we hear from our clients is just a sense of disillusionment, for example, Gosh, I went to this company, and they said they were going to handle all my debt, and they didn’t handle all my debt here. It is two years later and I’m still getting late notices. Or: Now I’m getting sued because they never did settle that debt.

People get frustrated, and they feel like they’ve put good money before bed.

Debt consolidation it’s kind of taking people for a ride, people who are vulnerable, and maybe even desperate, so debt consolidation it’s not annoying, it’s frustrating for our clients. 

Who Is Behind Some Of These Debt Consolidation Firms?

It is almost always law firms. As a business model, it probably appears like something that’s pretty low-stress for a career choice.

If you’re collecting debited money straight from an account that you’re going to get paid, which for lawyers is often a huge consideration: Are they going to pay you? And then, it’s just dealing with credit card companies.

Usually, it’s all about a law firm that will say that they’re doing this, they can solve your debt problems, and often just because of the system, they’re unable to deliver it.

How Do Student Loans Affect Debt Consolidation?

Student loans are not often considered the same kind of consumer debt as credit cards or loans.

Student loans will not go into a debt consolidation plan, if we’re talking about these companies that do that you can do your debt consolidation.

You can take out a home equity line of credit and repay your student loans.

Student loans don’t fall into the category of debt consolidation. You would need to deal directly with the servicer of your student loan.

The servicer is not necessarily the folks who gave you the loan, you’re not talking to the president who offered you your federal student loan, you’re talking to navient, greater lakes, or something like that that does the student loan servicing.

There is a way to consolidate if you had one loan or two loans for every semester you were in school, with the federal student loan organizations, to consolidate all of those but you’re with the same lender.

Then, you have one payment for all of your student loan debt but that’s a whole different thing.

Once you do that, then, there are different kinds of repayment options like pay-as-you-earn, income-driven repayment plans, and things like that under that kind of consolidation.

What’s The Needed Documentation When Someone Files Bankruptcy If They’ve Used Debt Consolidation?

What a bankruptcy lawyer would want to see is the contract for the debt consolidation company. We find contracts advantageous and very interesting.

We also need to know the contact information for the company that you used in your debt consolidation so that we know how to contact them, get your money back, see what is in trust and look at that full accounting,  all of that.

Then, just like with any other kind of bankruptcy, we need a list of your creditors. We pull credit reports but not everything is on credit reports.

Since July medical debt and derivatives of medical debt are not allowed to be reported on your credit reports, so you may have some medical debt, the number one reason for bankruptcy.

When you come to a bankruptcy lawyer, they are going to ask for all of that information. Who did you do the debt consolidation with? What is their contact information? Do you have that contract? And then, a list of all your creditors whether they were in that debt consolidation plan or not.

Which Chapter Is Better If You’re Looking To Go Through Bankruptcy For Debt Consolidation Or Better Manage Your Debts? 

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Language is important here, bankruptcy is not debt consolidation. There are Chapters of bankruptcy that may be a restructuring of your debt but it is not technically consolidation.

Chapter 7 doesn’t restructure anything, it’s meant to get rid of what can be gotten rid of, like medical debt, credit card debt, and things like personal loans that are unsecured things.

Chapter 7 is not intended for any kind of consolidation.

Chapter 13 and other kinds, either Chapter 12, or Subchapter 5, we’ve talked about not a consolidation but a restructuring of your debt.

Under that kind of Chapter 13 you propose a repayment plan that treats your creditors that are in the same category, unsecured creditors category called priority debt, secured debt, and treats all those people in those categories the same way.

All of your unsecured debt will be treated one way, and you might pay back zero dollars to your unsecured debt, you might pay back all the dollars of your unsecured debt, it depends on your plan and it depends on your income.

You want a good lawyer who’s great at calculating that kind of plan.

There’s no debt restructuring and no debt consolidation in bankruptcy but we are looking at a restructuring based on the different categories of debt you have, and what can be proposed in your case.

How To Unwind Debt Consolidation & Make That Process Smooth?

The hardest part of bankruptcy besides wrapping your mind around the fact that you’re filing bankruptcy is getting ready to file. 

The most difficult part should not be during the bankruptcy itself. Sometimes there’s some shifting in Chapter 13 and there is some back and forth with the trustee but the hardest part is done before we even file.

Let’s say you’ve called your bankruptcy lawyer, you’ve signed your retainer agreement and you’ve paid your fees. We’re going to ask for all the documents, we’re going to need:

  • Pay stubs.
  • Proof of other income.
  • Tax returns.
  • Bank statements.

When we see those bank statements we look through your transactions, we’re not here to judge whatever you want to spend money on is fine but if there’s anything that jumps out to us, it might jump out to the trustee, and so we want to make sure that all bases are covered.

Frequently that’s where we see payments going to debt consolidation companies, so if a client has forgotten to tell us that they’ve been involved in a debt consolidation plan, we might find that from their bank statements, and we’ll say: Hey, what’s this weekly money going out to this law firm? Then, we are going to have that conversation.

Like we said before, we’d like to see their contract, the contact information, and if any debt was settled how much was it settled for it, because that tells us you still could get taxed on the remaining amount we want to make sure we include in the bankruptcy, so you do not get taxed on that remaining amount.

Even if you think it was settled in full and everything’s free and clear, we like to list everything that we want to cast a very wide net for people who are filing a bankruptcy, so it’s one and done.

Get everything handled and there are no strings left at the end of it.

Further details here

Should you have additional questions about debt consolidation, bankruptcy, or your specific case, you may contact us at (855) 502-0555. After a brief 10-minute evaluation of your case over the phone, we will let you know what options you have. You can also follow us on our social networks so you don’t miss our weekly broadcasts on Facebook, YouTube, and Twitch.

Frequently Asked Questions About Debt Consolidation

Debt consolidation means having one payment for covering all your debts, and sometimes people take out a home equity loan, so they make that one payment, and then, they pay off their consumer debt.

In bankruptcy one of the main differences is that you have a more global kind of protection, the creditors by law are forbidden from taxing that forgiven income.

People will try anything to avoid bankruptcy, and it’s seen a lot of people trying out a debt consolidation solution, which is not exactly a solution, and when that falls through and they’re facing some other kind of consequence of crushing debt, then they call us, we’re the last call that people make.

About the Author: Amy Wilburn

Before falling in love with the law, Amy Wilburn was a French teacher for grades 7-12. In 2009, Amy transitioned to working for a bankruptcy attorney and right away, she knew she had found her calling. While working as a bankruptcy paralegal and raising her two young children, she attended Seattle University School of Law and earned her degree in 2014. She enjoys serving her clients and guiding them through the rocky waters of bankruptcy, with equal measures of professionalism and compassion. Now that she has an empty nest, she is throwing herself into time with her two dogs, Henry and Zoe. She watches Seahawks and Mariners games whenever she can, plays piano, enjoys quilting, and always loves exploring new places to hike and play.

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