Potential Pitfalls of Debt Consolidation

Many bankruptcy clients have sought the help of debt consolidation companies prior to filing for bankruptcy relief.  Debt consolidation can be handled in numerous ways.  You might take out a loan to pay off multiple accounts.  Or you might contact a company that will negotiate will all of your creditors on your behalf.  The creditors might agree to a lower payment amount or a reduced balance if you can make a one-time payment.  At first glance, combining all your debt in this manner may seem like a good idea.  However, there are several downsides you should consider.

Downside to Debt Consolidation

One downside is these consolidation companies only handle your unsecured debts.  If you are seeking relief or assistance in handling car loans or home mortgages you are out of luck going this route.  The automatic stay forbids creditors from trying to collect from debtors after they file bankruptcy.  However, a debt consolidation company has no power to bind the creditors to cease collection actions again you.  The creditors can continue harassing you for the debts that you owe them.

A big issue that is rarely told to clients involves the forgiven debt.  You could face tax implications if your debt consolidation company works out a settlement agreement with the creditor.  The IRS treats any amount of debt that is forgiven over $600 as additional income.  You will receive a 1099 at the end of the year from the creditor and so will the IRS.  However, your gross income does not include any amounts that are discharged in bankruptcy.  See 26 U.S.C. 108(a)(1)

I have also worked with clients that are being sued even though they are dealing with a consolidation company.  Sometimes these companies will deal with one creditor at a time.  The client is making monthly payments into the company thinking all of their debt is being handled.  When one company is getting their settlement payments multiple companies will be receiving $0.00 until the first creditor is paid.  This can lead to lawsuits, judgments, and wage garnishments.  This differs from filing bankruptcy as bankruptcy provides protection from all creditors as soon as you file your case.

Even though consolidating your debts might sound good at first thought, take a second and consider all of your options.  Bankruptcy is a very viable option that will truly provide you with a fresh financial start.