What to do if you are drowning in debt

A number of solutions can help you rebuild your credit if you are unable to pay your bills. Learn the pros and cons of many debt-reduction methods, including bankruptcy.

If you are drowning in debt and can't pay your bills, you need to act quickly to rebuild your credit. You have a number of solutions available, with bankruptcy as a last resort. We recommend reading the publication Surviving Debt. Expert Advice for Getting Out of Financial Trouble, put out by the National Consumer Law Center. It should also be available through your local library or contact:

What with all the recent news of foreclosures, this is a popular site and resource.

Contact your creditors

If you find you cannot make your payments, contact your creditors at once. If you have paid your bills promptly in the past, they may be willing to work with you. Do not wait until your account has been turned over to a collection agency. At that point, the creditor has given up on you.

You can ask creditors to rewrite your loans to extend the time you have to pay and to change the payments so that you can afford to make them. After all, what other choice do they have but to sue you, which will cost them a lot of money and cause a lot more headaches. The extensions will increase your overall cost because the creditors will charge you interest over a longer period.

Consider calling consumer credit counseling services

Consumer Credit Counseling Services (CCCSs) are not-for-profit organizations located in virtually every city. For a modest fee, the CCCS provides debt counseling services for families and individuals with serious financial problems. The Services are supported by contributions from banks, consumer finance companies, credit unions, merchants and other community-minded firms and individuals.

A credit counselor meets with you and analyzes your total financial situation. The counselor may develop a repayment plan and contact your creditors to arrange new repayment terms. The counselor also offers education and helps you design a budget so that you can stick to the repayment plan and avoid future financial difficulty.

Investigate credit rebuilders carefully

If you are having trouble paying your bills, you may be tempted to turn to a company that claims to offer assistance in solving debt problems. There are people who claim they can resurrect your credit. But be very careful. They are expensive and often involved in fraudulent schemes, which can leave you worse off than your original credit problems. 

Before signing with such a company, investigate it. Be sure you understand the services the company says it will provide and what it will cost you. Do not rely on oral promises that are not in the contract. Also, check with the Better Business Bureau and your state or local consumer protection office. They may be able to tell you whether other consumers have registered complaints about the company.

Be wary of loan consolidators

These private businesses lend you money to pay off all your debts. You then owe only one creditor—the loan consolidation company. The good news is that you pay only one check a month, you can repay over a long term, and you can make low monthly payments. The bad news is that the interest charged by loan consolidators may be very high, and you may be hit with a stiff fee for paying off the loan ahead of schedule.

Another danger is that a consolidation loan does nothing to resolve the habits and tendencies that often caused the credit problems in the first place. If you go to the trouble of setting up a consolidation loan, only to again build up an equally imposing mountain of debt the next time you have the opportunity to do so, you won't have accomplished much, and possibly will be worse off than before the consolidation. Unfortunately, this is all too common. And if you have pledged the equity in your home as security for the consolidation loan (usually known as "home equity" loans), you may end up both broke and homeless.

Use home equity loans strategically

Most credit counselors advocate the general rule that you should not convert unsecured debt into secured debt. Following this rule would mean not using your home equity to collateralize your credit card debt. Although this is certainly a logical and prudent rule, like most general rules, we think there are times where exceptions may be in order. For instance, such a loan may be appropriate if most or all of the following factors are true:

• you have home equity that you can tap into
• you presently have been able only to make the minimum monthly payment required on your credit cards
• your credit card debt carries very high interest compared to what you could obtain for a home equity loan
• you would meet the qualifications that would make interest to be paid on the home equity loan deductible on your federal income tax return
• you will pay back the home equity loan on a relatively short payment schedule—probably five years, but no more than 10 years (remember: if you are only paying the minimum monthly amount required on a large charge balance, your account may not be paid in full for 20 years or more)
• you have an adequate and dependable source of income available to repay the home equity loan
• you have made the necessary adjustments to your lifestyle and personal finances necessary to ensure that you won't slide back into the credit card debt morass once your existing credit balances are extinguished—this is probably the most important factor

Consider bankruptcy only as a last resort

The federal bankruptcy laws provide debtors with an opportunity for a fresh start. In turn, they provide creditors with an orderly, equitable means of allocating the debtor's limited resources among them. 

Bankruptcy is a complex and multi-faceted legal concept. We'll only briefly review the types of bankruptcy filings and what bankruptcy filings can and cannot do. If you're considering this course of action, seek the advice and assistance of an attorney experienced in bankruptcy law. We also recommend reading our asset protection article.

Types of bankruptcy

The Bankruptcy Code is divided into chapters. A debtor who is an individual (as opposed to a business entity) typically can make one of two choices for filing bankruptcy: a Chapter 7 "Liquidation" (the traditional bankruptcy) or a Chapter 13 "Adjustment of the Debts of an Individual with Regular Income."

Upon the filing of any bankruptcy petition, an automatic stay goes into effect. This is of key importance because the stay forces an immediate halt to repossessions, foreclosures, evictions, garnishments, attachments, utility shut-offs and debt collection harassment. It offers the debtor a breathing spell during which the debtor and the bankruptcy trustee can review the situation and develop an appropriate plan. Creditors cannot take any further action against the debtor or the property without permission from the bankruptcy court.

Chapter 7

In a chapter 7 liquidation, the bankruptcy court appoints a trustee to examine the debtor's assets. All the assets will be identified by the trustee and categorized as exempt or nonexempt property. 

• Exempt property, limited to a certain amount of equity in the debtor's residence, motor vehicle, household goods, life insurance, health aids, specified future earnings such as Social Security benefits and alimony, and certain other personal property, remains the property of the debtor.
• Nonexempt property becomes subject to bankruptcy, and the trustee then sells the nonexempt property and distributes the proceeds among the creditors. 

Although a liquidation can rarely protect a debtor from a secured creditor (the secured creditor still has the right to repossess the collateral), the debtor will be discharged from the legal obligation to pay most unsecured debts such as credit card debts, medical bills, and utility arrearages. Even certain types of unsecured debt are allowed special treatment and cannot be discharged. These include some student loans, alimony, child support, criminal fines, and some taxes.

Chapter 13

In a chapter 13 adjustment of debts, the debtor puts forward a plan, following the rules set forth in the bankruptcy laws, to repay all creditors over a period of time, usually from future income. A chapter 13 adjustment of debts may be advantageous because it allows the debtor to catch up on mortgages or car loans without the threat of foreclosure or repossession and allows the debtor to keep both exempt and nonexempt property.

The debtor's plan is a simple document outlining to the bankruptcy court how the debtor proposes to pay current expenses while paying off all the old debt balances. The debtor's property is protected from seizure from creditors, including mortgage and other lien holders, as long as the proposed payments are made. The plan generally requires monthly payments to the bankruptcy trustee over a period of three to five years. Arrangements can be made to have these payments made automatically through payroll deductions.

What bankruptcy can and cannot do

Bankruptcy can make it possible for a financially distressed individual to:

• Discharge liability for most or all outstanding debts and get a fresh start. When the debt is discharged, the debtor has no further legal obligation to pay it.
• Stop a home foreclosure action and gain the opportunity to catch up on missed payments.
• Prevent repossession of a car or other property, or force the creditor to return property even after it has been repossessed.
• Stop wage garnishment and other debt collection harassment, and get some breathing room.
• Restore or prevent termination of utility service.
• Lower the monthly payments on debts, including secured debts such as car loans.
• Challenge the claims of certain creditors who have committed fraud or who are otherwise seeking to collect more than they are legally entitled to.

Bankruptcy cannot cure every financial problem. It is not possible to:

• Eliminate certain rights of secured creditors. Although a debtor can force secured creditors to take payments over time in the bankruptcy process, a debtor generally cannot keep the collateral unless the debtor continues to pay the debt.
• Discharge certain payment obligations, such as child support, alimony, some student loans, certain court-ordered payments, criminal fines, and some taxes.
• Protect cosigners. If a relative or friend co-signed a loan which the debtor discharged in bankruptcy, the cosigner may still be obligated to repay the loan.
• Discharge debts that are incurred after bankruptcy have been filed. This is a very important consideration when determining the timing for filing a bankruptcy petition.

Bankruptcy's effect on your credit

Federal law allows for a bankruptcy to be recorded as part of a debtor's credit history for 10 years. Whether or not the debtor will be granted credit during the years following bankruptcy is unpredictable. 

In some cases, it may actually be easier to obtain credit as potential new creditors may feel that, because the old debts have been discharged, they will be first in line for future payments. They also recognize that the debtor cannot file again for bankruptcy for at least the next seven years.

Debtors can, after bankruptcy, voluntarily pay a discharged debt to a creditor, such as a doctor or hospital, toward whom they feel a special moral obligation or with whom they wish to maintain credit. Such payments are voluntary, do not reaffirm the past obligation and do not create a new obligation.