The Dangers of Non-Bankruptcy Credit Consolidation

The Bankruptcy Act of 2005 wrote in a number of provisions that “encourage” potential bankruptcy debtors to consider non-bankruptcy debt relief such as Credit Consolidation.  The problem with Credit Consolidation is that it is not regulated and is not a global settlement of debts.Also, the cost of credit consolidation is usually between 30 to 50 cents on the dollar which typically is more expensive than what most debtors pay in a Chapter 13 Bankruptcy.

Just last week, Lisa Madigan, Illinois Attorney General filed a Cease and Desist Order Against Legal Helpers, an Illinois Based Debt Consolidation Firm under the new law effective January 1, 2011, that prohibit any non-lawyer from offering non-bankruptcy debt consolidation.

So what’s the solution?  Bottom line is this: If you are wealthy enough that a bankruptcy is more harmful than good, the traditional route to take is to spend some serious money on legal fees to restructure you debt and also defend lawsuits as they arise.  For most people’s debts that are beyond their ability to pay, bankruptcy is the only safe choice because it is court supervised and is global in its effect.  This is not to say that Bankruptcy is the best debt relief ever, but is simply to say that only in a bankruptcy can you get the automatic stay which stops all lawsuits and debt collections from happening without court order.  Also, in a bankruptcy,  a repayment plan uses long established and well thought out priority rules to determine which debts are paid in preference to other debts.  Lastly, all parties in bankruptcy proceedings generally have attorneys, which helps to ensure that the focus is on debt relief and not on silly mistakes of procedure or allowing one creditor to have preference over another.

Here is a typical example of why non-bankruptcy debt relief through non-attorney assisted credit consolidation is now prohibited in Illinois:

Sally and Ben are married with two children.  Their family income is $50,000.  They have $2000 of tax debt from last year, Ben owes child support arrears to his ex-wife in the amount of $10,000 and Sally has $60,000 in credit card debt.  Ben and Sally own a modest home with an $80,000 mortgage and $500 per month payments.  Ben and Sally are 4 months behind on their mortgage payments and are about to have foreclosure lawsuit filed against them.  Sally has two court judgments against her.  Both have been sent to collections.  15% of Sally’s gross income is being deducted each month for these garnishments.  Currently Sally will be in garnishment for 5 years before they are paid off.

What should they do?

If they file a Chapter 7 Bankruptcy, all of the credit card debt will be gone, and they can surrender their house and move out in approximately 6 months. Ben will still be garnished for his child support arrears up to 50% of his gross income, and he and Sally will also have to make steep payments on their back taxes.  The family will move into low quality rental housing within 9 months.

If they file a Chapter 13 Bankruptcy, all of the credit card debt will be paid at 10 cents on the dollar or $6000 over 60 months.  The arrearage on the home mortgage will be paid first without interest and is approximately $2000 over 60 months.   The tax debt will be paid back before all other creditors at 100% with 9% interest over 30 months.  Ben and Sally will be able to keep their home.  Ben will pay back all of his child support arrears without interest over the 60 month plan at 100%.  In this case, the garnishments stop, meaning that the family now only pays 10% of its gross income not to just two unsecured creditors but in satisfaction of ALL of the unsecured creditors.  This is where the good deal is.  Also – if Ben and Sally had a car loan, it would be converted today to 6.25% interest with payment spread out over 60 months.

If they went with debt consolidation, Ben and Sally would most likely pay $4500 for debt consolidation services up front.  Then they would pay approximately $1200 per month for at least 36 months.  At the end of the 36 months, the creditors who voluntarily agreed to a reduce payoff would be gone and paid off.  The creditors who did not join in would still be owed money and most likely would have filed a lawsuit for collection and have entered a garnishment against Ben and Sally.  The Child Support would be paid through garnishment of Ben’s salary up to 50% of his gross income, and the tax debt would be paid through a tax lien which would tie up all of their real and personal property, freeze their bank accounts and ruin their credit rating.

Bottom line: when the Bankruptcy Reform Act of 2005 was enacted, part of the goal was to increase the payout to credit card companies.  This has been accomplished by increased payouts under Chapter 13 plans and the means test that forces everyone with above mean income into a Chapter 13 repayment plan.

Bottom line: voluntary credit consolidation was bad for most people prior to 2005, and it is still bad today.

Only the very rich with very private and expensive attorneys benefit from these types of restructuring, and usually it is done to simply keep control of many assets with very little equity but lots of income.

For more information about debt relief through bankruptcy, please email  or call 877-GO-GO-NLO to set up a free bankruptcy consultation.
