Will credit card consolidation benefit me and what are the pros and cons of credit card or debt consolidation?

Posted at 1/28/2013 5:37:00 PM by Mucklow

Credit card consolidation has little to no benefit to a Debtor in serious financial trouble.  Here are some things you need to know about credit card consolidation that companies performing these services will neglect to tell you or it may be hidden in the fine print of contracts.

First, the cost of these services can be extremely high compared to the attorney fees regulated by all federal bankruptcy courts.  Fees for consolidation companies are generally not regulated and are usually higher than Chapter 13[1] .  Chapter 13, which functions similar to a consolidation, but has many more benefits, has a no look fee regulated by the Court between $2,500 and $4,000 in most jurisdictions, which is paid over the course of the case after the planned repayment is confirmed by the Court.  Debt consolidation companies charge their fees up front typically and before any funds are disbursed to pay a single creditor.  This fact is not normally discussed up front with the Debtor, but is contained in the fine print of the contract.  The Debtor may believe that he is making payment on his credit card debt, but no funds are disbursed to creditors until the fees owed to the consolidation company are paid first.  Some credit consolidation companies are funded by credit card companies creating a conflict of interest and propagate misinformation about the rights of Debtors and have been known to provide advice that worsens the Debtor's plight.

Because the consolidation company is paying itself first, the creditors are not receiving funds and the Debtor's credit worsens because no funds are distributed.  Additionally, the consolidation company typically will negotiate lower payments or lower interest rates, which causes further damage to the credit.  These individual creditors will report to the credit bureaus slow payment, non-payment or deviated terms such as consolidation.  The credit score worsens if debts are not paid pursuant to terms and on time.  Chapter 13 on the other hand freezes all unsecured debt such as credit cards, pay day loans, medical bills, loan deficiency claims, and other types of lawsuits[2].

Debt consolidation is dependent upon the creditor's voluntary participation.  Chapter 13 does not require the creditor's agreement to participate; the terms of the plan are "crammed down" over creditor objection.  The terms of the plan are designed by debtor's counsel based upon various factors such as the value of non-exempt assets and excess funds in the Debtor's personal budget[3].    In other words, it takes only one creditor to refuse to participate, file suit in court, and debt consolidation is wrecked and all fees and payments are forfeited.  In Chapter 13 all creditors are stayed by the federal injunction incorporated into Section 362 of the Code, known as the automatic stay, and must participate and failure by the creditor to file a claim results in non-payment of the amounts owed which benefits the Debtor.

Debts are often sold and assigned to collection companies.  Without an agreement and waiver with the original creditor, negotiating with the collection company many not end collections of the underlying debt because it may be sold over and over resulting in delayed harassment to the Debtor.  Chapter 13 cuts off the rights of creditors permanently so that the Debtor gets a fresh start.

Creditors are required to issue a Form 1099 to the Debtor for forgiveness of debt.  This fact is often not disclosed by consolidation companies except perhaps in the fine print of the paperwork.  Forgiveness of debt can lead to a tax liability at the end of the year because it is considered as income by the IRS.  In contrast, Chapter 13 prohibits the issuance of a Form 1099 and there is no tax consequence to filing a chapter 13 petition.

In Conclusion, Chapter 13 provides greater protection to the Debtor and typically costs less.  There are many other benefits to Chapter 13 such as stopping foreclosure, sheriff sales, and repayment of mortgage arrearages, readjustment of vehicle loans (and lowering of the interest rate), stopping repossession of vehicles and property, and adjustment of tax liabilities (1040 returns filed on time and more than three years old are dischargeable), student loans, reinstatement of driver licenses, stopping utility shutoff and many more benefits not covered here.  Debt consolidation does have a place in the world of debtor/creditor strategy, but normally it should be used sparingly under limited circumstances based upon availability of assets, fraudulent transfer law, income, the age of the Debtor and other factors.

[1] Legislation has been introduced in some states to regulate debt consolidation companies due to abuses.  The State Attorney General office can bring cases against these companies for consumer fraud and victimizing debtors.

[2]Although guaranteed student loan debt can be restructured in Chapter 13, generally interest will continue to accrue on the loans while payments are reduced through the plan.  Non-guaranteed loans and tuition bills can be discharged in Chapter 13 and the claims are frozen with no interest accruing.  Typically a small percentage is paid to the unsecured creditors pro rata.

[3]Either federal or state exemptions protect the Debtor's assets to certain levels.  In Ohio the Debtor's equity in real estate is protected up to $21,625 for a single debtor or $43,250 for a married couple.  Equity is determined by subtracting the principal balance of the mortgage(s) from the current market value.  Other exemptions cover vehicles, retirement accounts and personal property.  The Debtor's budget is based upon net income less mortgage or housing payments, insurance costs, utilities, food and other living allowances.

 
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