Bankruptcy and Debt Conversation

How are the new bankruptcy laws impacting consumers? What can people do to keep their credit healthy? How does the financial industry need to change? In an email conversation on October 20, 2005, Credit.com brought together industry experts and discussed these topics and other credit issues. This conversation included:

John Ulzheimer, Credit scoring and credit reporting expert, author and President of Credit.com Educational Services. Formerly with Equifax and Fair Isaac, John shares his unique insight of the inner workings of credit scoring models and the credit reporting industry on CreditBloggers.com.

Gerri Detweiler, Personal finance author, radio host and credit expert. Gerri contributes budgeting, debt recovery and savings information online.

Emily Davidson, a former TransUnion credit expert. Emily writes educational articles, advocates for consumers, works with reporters and leads CreditBloggers.com as a part of the Credit.com team. Emily moderated the following discussion with Gerri and John in October.

Emily: Welcome John and Gerri, let’s get right to it. With recent changes in bankruptcy laws, more people may be thinking twice about filing for bankruptcy. What alternatives do consumers have to choose from?

John: The goal of the new bankruptcy law was to curb what many felt was an abuse of the current system. Now anyone who wants to file a bankruptcy will have to go through mandatory credit/budget counseling. Notice that I didn't call this "free" counseling. They will likely have to pay a fee for the counseling session.

Next, they'll have to show what their income was over the past six months. This information will be used to determine whether or not they have the means to continue to pay for their debts through a Chapter 13. This is the "means test" that you may have heard about.

If they have an income that is equal to or greater than their state median, then they'll have to file a Chapter 13. The exception is if their expenses are such that they won't have anything left after making payments. Any attempt to file a Chapter 7 will be challenged by creditors (called a "move to dismiss") if the trustee advises them that the consumer doesn't qualify based on the means test.

And...a Chapter 13 bankruptcy is much more expensive to file than a Chapter 7 and the costs will only increase because of the additional amount of paperwork that has to be filed and maintained. The cost to file a Chapter 7 (In the Atlanta area) is roughly $700 while a Chapter 13 is around $1,800-$2,500.

As far as alternatives to filing bankruptcy...those are really the same as they were before the law. Consumers can ride out the storm and pay the debts themselves or they can with no bankruptcy protection. They can also certainly still go to a non-profit credit counselor and sign up for one of their debt management programs (DMP). They certainly still have those options.

The new law will make the option for a Chapter 7 a "non-option" and will push more people into Chapter 13's...thus making it harder for them to recover credit wise.

Gerri: Many people will still qualify for a Chapter 7 under the new law, based on income. Even those lower income consumers, however, will find it more expensive and difficult to file due to new paperwork burdens, as well as new requirements that may make it more difficult to keep their homes and cars. Unfortunately, many of those consumers currently struggle to come up with the money they need to file and this will only make a bad situation worse.

Emily: Since Chapter 13 bankruptcy makes it so hard for people to rebuild their credit, what alternatives do people in financial distress have that may be better? Is credit counseling or debt settlement a better option credit-wise?

John: I don't believe so. Credit counseling or debt settlements are designed with having the goal of getting people out of debt. They do not have the goal of improving a consumer's credit report or score.

There is a fundamental difference between managing your credit to get out of debt and managing your credit to improve your scores. These two goals (or the multiple others) will not have similar impacts to your credit reports or credit scores. This is where consumers get in trouble.

What consumer's don't realize when going through counseling is that their actions will have an impact on their credit reports and credit scores for years to come. In their case it might be the lesser of two evils but it's still important for a consumer to be fully informed as to the effects of their actions. In the case of debt management programs and other debt settlements...they are not fully advised.

I'm not condemning the debt counseling industry...the fact is that they are simply not qualified to advise a consumer on what will and will not hurt their reports and scores. That's not their core competency. In fact, I'm not sure anyone other than the very few people who really understand scoring is qualified to give that sort of advice. I know through my experience that the parties that need to be talking aren't.

In a perfect world, the folks who offer debt management services would collaborate with credit bureaus, lenders and the scoring model developers to create a comprehensive approach to debt management that accomplishes the following:

1. Getting the consumer to a position where they can still make some sort of satisfactory payments without having to file for bankruptcy.
2. Keep lenders happy so that they do not elect to report deficiency balances to the credit bureaus.
3. Provide for universal credit bureau reporting standards that guarantees consumers fair reporting on accounts that are being paid through non-profit services
4. Maintain credit scores as they are at the time of the debt management program or debt program and offer an action plan that will reward the consumer with higher scores after they have completed their end of the debt management program bargain.
The goal isn't to give them ready access to more and more credit but to give them access to less expensive credit when they do re-enter the market.

Emily: Gerri, would you to follow up on John's idea? In the perfect world, what would debt management services and credit counselors do for consumers that they aren't doing today?

Gerri: I agree with John's assessment and will add my two cents.

In a perfect world, consumers would not be charged the very high interest rates some issuers are charging today. Remember, these rates used to be illegal in some states, and have been instituted at a time of historically low rates overall. They are one of the reasons consumers have flocked to bankruptcy courts.

Also in a perfect world, creditors would be more flexible in their repayment plans offered through credit counseling agencies. Many consumers must pay back 100% of their debt in counseling, and often with some additional interest continuing to accrue. However, by the time they get to counseling they have already paid high interest rates for some time. I'd like to see more generous concessions in the payment plans to help consumers avoid bankruptcy. There is a provision in the new law that may provide that relief. Under that section of the new bankruptcy law, consumers can offer a repayment plan through a counseling agency that will repay at least 60% of their debt, and if creditors unreasonably won’t work with them, they may have to collect less money in the bankruptcy. It appears to be too early to tell how that will work in practice.

Every consumer I've spoken to wants to avoid bankruptcy, but often it's very difficult to do that given their levels of debt, the interest rates they are paying and the fact that many are earning less than what they used to do to layoffs, cut backs, etc. The common refrain: I want to pay my debt but how can I? They won't work with me.

Emily: Here’s another question for both of you: Consumers who are close to filing for bankruptcy or working with debt counselor are often susceptible to predatory lending and other scams. What are some things that people need to look out for when they a dealing with major financial problems?

John: Good points, Gerri. Emily, you're correct. These consumers are a target of scams. In fact, there are lenders (and, so called, "real estate investors") who specialize on focusing on those very people because they know they are desperate and won't be offered help from mainstream lenders.

I think step one is to educate people on the fact that they are, in fact, a target. They may not even realize it. And that any "offer" they get from anyone to help them should be heavily scrutinized.

Step two...never, ever, offer your house as collateral. Avoid signing anything (especially a quit claim deed) without having a lawyer or trusted expert review it and explain it in real English so that anyone can understand the terms.

A common scam that I hear about in Atlanta (I don't know if it's illegal but if it isn't...it should be) is the "I'll refinance your house" game.

The target seems to be elderly and/or undereducated homeowners. For example, a person lives in a house (and has for years or decades) so they've got tons of equity built up in the house (either by paying down the loan or appreciation...or both). Some scam artist comes in and offers to refinance the loan (reverse mortgages are common here) which puts them in primary lien holder position. The restrictions on the new loan are normally so off the charts that any late payment can result in escalating payments and eventually foreclosure. The new owner gets the house (and all of the equity) for pennies on the dollar and then flips it.

I think the best action is to be proactive and look for the solution yourself rather than having the solution find you. You're less likely to be taken advantage of especially if you can work with reputable lenders or be referred by people you trust.

Gerri: People I speak with are so desperate for an alternative to bankruptcy that they are vulnerable to scams. I get lots of questions, for example, about “debt elimination” programs that claim they can legally eliminate debt. I’ve interviewed several consumers who paid thousands of dollars to these companies, and had to file for bankruptcy anyway. I worry that it will get worse when consumers believe (often incorrectly) that they can’t file anymore due to the new law.

Emily: How do you think that recent increases in credit counseling (especially under the new bankruptcy requirements) will impact regulation of this industry and new credit reporting policies in the future? We've already seen an IRS crack down on their non-profit status, is this a possible trend?

John: The IRS is already all over the non-profits. In fact, I believe they've penalized a couple because they were more for-profit than not. I think any non-profit financial counseling agency has either already gone through an audit or is on their list and has been for years. So, I'm not sure this is going to accelerate any sort of change in regulation for non profits.

Also, we just had a sweeping change to the FCRA at the end of 2003 (FACTA) so I'm not sure this is going to reopen the discussions about credit reporting policies any time soon. I could be wrong but I just don't see them tackling the FCRA again for years.

I think with sweeping legislation like this it will take time to allow everything to shake out and develop...and then we can react.

It would be nice to have a crystal ball and know what the bankruptcy laws were going to do but that's not the case. Did they think that the deadline to file would have accelerated Delta Airlines and Delphi's decisions to file for bankruptcy protection and then lay off thousands of unionized workers? Of course they didn't. But, that's what will happen.

And what about the young person who has an expensive advanced degree (and the student loans to prove it) in an industry that doesn't normally pay well (like art or literature)? Those folks (teachers for example) are probably making more than the state median income but still have six figures in student loan debt that can't be discharged. Did they intend on that?

To qualify to be on the list as an approved credit counselor takes some work. I've seen the application and it's a bear. The folks who are being approved are the Consumer Credit Counseling Services (CCCS's) and some others. This is good as it allows them to make some money. Why is this important? Because their "fair share" from lenders (via debt management programs) is going down and will continue to go down because of the new bankruptcy law. In fact, some of these counselors are selling out to larger CCCS organizations and laying off employees.

Was this intended under the new act? Of course not. But, it's happening. We'll have a clearer picture in 12 months as to the impact of the new law.

Emily: What other advice do you have for people with financial problems who are considering their options?

Gerri: My overall main suggestions are:

1. Keep your eye on the prize. Your main goal is your long-term financial health. People often make poor choices based on avoiding temporary pain (for example, a lower credit rating, downsizing the car, or a more frugal lifestyle). Focus on the positive goal of putting this behind you.
2. Expect the best and plan for the worst. Elizabeth Warren, author of The Two Income Trap, warns about the danger in false optimism and she's right. Most people I talk with waited too long to get help, or kept hoping things would change more quickly than they did.
3. Keep your options open. Even if you have a bias against credit counseling or bankruptcy, be open to the best option for your situation. There's usually no "perfect" solution, so be flexible and willing to consider all the alternatives. Again, do that before you make costly mistakes.
Emily: This has been a great conversation. Thank you Gerri and John for participating. I hope we’ll have another discussion like this very soon.