Are you struggling with significant debt and thinking about bankruptcy? Before you decide, it’s essential to understand all your options. This guide provides clear and practical alternatives to bankruptcy, designed to equip you with the knowledge and confidence to manage your financial situation effectively.
What Are the Alternatives to Filing Bankruptcy?
Bankruptcy should be a last resort due to its long-lasting impact on your credit score. Fortunately, there are several effective alternatives that might better suit your needs.
Credit Counseling
Credit counseling can be an option when you find yourself overwhelmed by debt. This service is typically provided by certified nonprofit organizations that specialize in financial advice and solutions. These agencies are accessible nationwide and are designed to help individuals understand their complete financial picture, including income, debts, and monthly expenses.
During a typical session, a credit counselor will work with you to:
- Assess your financial situation: They gather all relevant financial information to create a comprehensive view of your finances.
- Develop a personalized budget: Using this information, they can help you craft a budget that fits your income and helps manage expenses.
- Offer financial education: Counselors provide workshops and tools to improve your financial literacy, empowering you to make better financial decisions in the future.
- Propose a debt management plan (DMP): If appropriate, they might suggest enrolling in a DMP, which consolidates your monthly debt payments into one manageable sum that you pay to the counseling agency, which then disburses payments to your creditors on your behalf.
This proactive approach can prevent the need for bankruptcy by getting your finances back on track before they spiral out of control. But this option can also foster stains on your credit that can last for years, as it can result in a continued stream of late payments.
This is because some creditors will report your payments as “late” every month if you are not making full payments, even if the partial payments were agreed to by the creditors. You should also be aware that some of the non-profit counseling firms were set up by the credit card companies themselves to protect the interests of the credit card companies as much as yours.
Debt Consolidation
Debt consolidation is especially useful for those who have multiple balances with high interest rates, such as credit card debts, but who have also maintained current payments. The essence of this strategy is to combine all existing debts into one loan with a lower interest rate or longer paydown period, which can lead to significant savings and simplify your finances with a single monthly payment. Options for consolidation include:
- Personal loans: You can use these loans to pay off all your debts, then repay the loan at a fixed interest rate over a designated period.
- Home equity loans: If you have equity in your home, you might consider borrowing against it to clear your high-interest debts, often at a lower rate than other types of loans.**
- Balance transfer credit cards: These cards often offer an introductory 0% APR for a limited time, allowing you to transfer and consolidate other credit card balances.
**Home equity loans require relatively high credit scores of 680 or higher. So if you have equity in your home but your credit score is already suffering, you can also consider a cash-out refinance of your first mortgage – which is discussed below.
It’s crucial to not accrue additional debt on these accounts after they’ve been paid off; otherwise, you could find yourself back in a precarious financial position.
Creating A Debt Management Plan
A Debt Management Plan (DMP) is more than just a payment agreement. It’s a comprehensive strategy handled by credit counseling agencies that negotiate with your creditors to potentially lower interest rates and waive certain fees, extending the repayment period but making monthly dues more manageable. Key features of a DMP include:
- Consolidation of payments: Instead of multiple payment deadlines, you make one monthly payment to the counseling agency.
- Reduction of interest rates: Agencies often negotiate lower rates with creditors, reducing the amount of interest accrued.
- Structured repayment timeline: Most DMPs aim to clear debts within three to five years, offering a clear endpoint to your debt.
While entering a DMP can initially affect your credit due to the necessity of closing credit lines, it is structured to help you manage payments more effectively and can ultimately lead to improved credit health. Similar to the issues of credit counseling discussed above, these plans can also adversely impact your credit as a result of late payments reported by creditors (even if you are paying according to the plan).
Debt Settlement
Debt settlement should be considered when other options like consolidation or management plans are not viable. This process involves negotiating a pay-off amount with your creditors that is less than what you currently owe. The key components of debt settlement include:
- Settlement companies: These for-profit organizations negotiate with creditors on your behalf, often suggesting you divert your monthly debt payments into a savings account to build up a lump sum.
- Lump-sum offer: After accumulating enough funds, the company offers this sum to creditors in exchange for forgiving the remaining debt.
- Risks involved: This method can severely impact your credit score due to non-payment of debts during the accumulation phase. High fees and the uncertainty of creditor acceptance also pose significant risks.
Is Restructuring or Refinancing My Mortgage a Viable Option to Avoid Bankruptcy?
Homeownership comes with significant financial responsibilities, primarily your monthly mortgage payments. If these payments are becoming unsustainable, restructuring or refinancing your mortgage might be strategic alternatives to help manage your financial burden more effectively.
There are three options when it comes to your mortgage: (1) a rrestructuring or loan modification; (2) a rate and term refinance; and (3) a cash-out mortgage. The latter of the three is often the best option for debtors and we will explain why below.
What Does It Mean to Restructure or Modify Your Mortgage?
Mortgage restructuring involves modifying the terms of your existing loan to make the payments more manageable. This could mean extending the term of your loan, reducing the interest rate, or converting from a variable-rate to a fixed-rate mortgage. The goal is to lower your monthly payments to a level that alleviates financial stress and helps you avoid the drastic step of filing for bankruptcy.
When considering this option, the first step is to contact your mortgage lender or servicer (the entity that collects your payments) to discuss your current financial difficulties. It’s important to be transparent about your financial situation and the risk of bankruptcy, as this may motivate the lender to offer more flexible terms. Lenders/servicers might propose temporary or permanent changes to your mortgage terms, including:
- Payment Deferral: Allowing you to skip a few payments and adding them to the end of the loan period.
- Rate Reduction: Lowering your interest rate to reduce your monthly payment amount.
- Term Extension: Increasing the length of your mortgage term to spread out payments more thinly over a longer period, thereby reducing the monthly financial burden.
Each of these options has different implications for your total payment over the life of the loan and should be considered carefully. For instance, while extending the loan term can reduce your monthly payments, it may increase the total amount of interest you pay over the life of the loan. Please note, however, that while these loan modifications were more prevalent after the 2008 financial crisis, they are much more difficult to obtain now.
How Does a “Rate and Term” Refinance Work?
A “rate and term” refinance of your mortgage involves taking out a new loan with different terms to replace your existing mortgage. This can be an effective strategy if you can secure a lower interest rate or a longer repayment period, as either can significantly decrease your monthly payments. Key considerations for refinancing include:
- Interest Rates: Refinancing is most advantageous when interest rates have dropped since you took out your original mortgage. As of the date of this blog, however, rates have been rising for several years – making it less likely for borrowers to refinance into a lower rate.
- Loan Term: Extending the term of your loan during refinancing can spread out the debt and lower monthly payments.
- Credit Score Requirements: To qualify for the best refinancing terms, you generally need a good credit score. Lenders use your credit history to assess risk and determine the interest rate they will offer. If you are reading this blog, however, it is likely that your credit score is impaired by high consumer debt levels which will make it less likely that you will be able to refinance with better terms.
- Closing Costs: It’s essential to consider closing costs as well, as they can range from anywhere from 2% to 5% of your loan amount, depending on the size of your loan and the area where you refinance. Many lenders though are often able to roll closing costs into the loan by increasing the loan amount slightly or to pay for closing costs with a “lender credit” in exchange for a slightly higher interest rate.
How Does a “Cash Out” Refinance Work? (The “Golden Ticket”)
A “cash-out” refinance of your mortgage involves taking out a new loan that is larger than your existing mortgage. While these loans require sufficient equity in your home, they can be your “golden ticket” if they can provide enough cash out to pay off the debts with which you are struggling. This is the case even if current interest rates are much higher than where rates were when you obtained your original mortgage. By consolidating a substantial portion or all of your consumer debts into your mortgage, you can both extend the term of your consumer debt payments and lower the effective interest rates of your consumer debt by turning consumer debt into mortgage debt. Debtors can often save thousands of dollars per month by doing so and make their debts much more manageable – when they only need to worry about one payment.
- Equity Required: FHA mortgages require a 20% equity cushion at the time of funding for a cash-out mortgage. If your current mortgage plus all or most of your consumer debts add up to 80% of the value of your home or less, you have sufficient equity. VA loans (for veterans and active-duty service members) allow you to obtain a cash-out mortgage equal to 100% of the value of your property.
- Credit Score Requirements: THIS is the most advantageous factor when it comes to these cash-out refinances, as many debtors facing bankruptcy have relatively low credit scores. FHA, however, allows for credit scores as low as 580, and even lower in some cases.
- Paying Off Debt To Qualify: This is another extremely important factor, as many debt-laden borrowers believe they cannot qualify for a refinance. But fortunately, FHA and other loan programs allow borrowers to “pay off debt to qualify,” meaning that loans are underwritten under the assumption that certain consumer debts will be paid off in escrow with the proceeds from the cash-out refinance.
Strategic cash-out mortgages often enable debtors to avoid bankruptcy altogether.
Strategic Considerations
Once again, if you are reading this blog, it is likely that your consumer debts are near unmanageable levels and that your credit score may not be as high as it was once. In light of that, a loan modification or restructuring may be a better option than a rate and term refinance. This is particularly the case if the current interest rate environment is higher than where it was when you obtained your original mortgage. While borrowers have nothing to lose by requesting a loan restructuring from their lenders or servicers, they should be aware that successful loan restructurings are rare in today’s mortgage environment.
If borrowers have equity in their homes, a “cash-out” refinancing is often the best option for borrowers with more debt than they can handle for a variety of reasons. FHA, for example, is very flexible when it comes to credit scores and qualifying – and cash-out refinances can eliminate problematic debt, cut overall monthly payment obligations substantially, and often help borrowers avoid bankruptcy entirely.
What Are the Consequences of Filing for Bankruptcy?
Bankruptcy can drastically affect your financial standing. Chapter 7 bankruptcy, while clearing most debts, will stay on your credit report for ten years and may necessitate the liquidation of assets. Chapter 13 bankruptcy, on the other hand, allows for a structured repayment plan over three to five years but still impacts your credit report for seven years. Bankruptcies can also prevent you from obtaining competitive mortgages for years in most cases.
How Can I Avoid Bankruptcy and Improve My Financial Situation?
Addressing your financial woes without resorting to bankruptcy involves a comprehensive approach:
- Create a Budget: Start by outlining all income and expenses to understand your financial flow and identify potential savings.
- Increase Income: Consider taking on a part-time job or engaging in gig economy opportunities to raise extra funds. We realize though that this is easier said than done – particularly if your days are already full.
- Reduce Expenses: Examine monthly expenditures closely. Cancel unnecessary subscriptions and look for cheaper alternatives for essential services.
- Cash Out Refinance: If you have sufficient equity, this is probably the most effective avenue for avoiding bankruptcy.
Frequently Asked Questions
How can refinancing my home help me avoid filing for bankruptcy?
A “rate and term” refinance can lower your mortgage payment if the term is extended and/or if the interest rate is lowered. This in turn can free up additional cash to pay down your consumer debts faster. A cash-out refinance, as explained above, can be a much more effective avenue for avoiding bankruptcy. This is because the cash out can be used to pay off your consumer debts and potentially save you thousands of dollars every month.
What are the risks of using refinancing as a strategy to prevent bankruptcy?
Refinancing can lead to higher overall interest costs if you extend the loan term or get a higher rate via a cash-out refinance. A cash-out refinance will also reduce your home equity, which is only a risk if you intend to sell in the near future with a plan to use your net proceeds for another purpose.
You should also be aware of closing costs and potential penalties for an early mortgage payoff, but prepayment penalties are rare in today’s mortgage environment. Overall, though, the risks from a refinance are minimal relative to the potential benefits.
How low can my credit score be if I want to refinance?
FHA allows accommodates credit scores as low as 580 and even lower in some cases. Home Equity Lines usually require credit scores of 680 or higher.
How much equity do I need if I want to refinance?
An FHA cash-out mortgage only requires a 20% equity cushion at the close of escrow.
What is the first step if I’m considering bankruptcy?
The first step should be to consult with a mortgage advisor who has experience with cash-out mortgages for borrowers with excess debt or credit issues. A strategic cash-out mortgage can often eliminate most of the financial stress that is pushing borrowers to the brink of bankruptcy.
If a refinance is not an option, borrowers should consider credit counseling. However, they should proceed with caution because credit counseling can sometimes impact credit more severely than bankruptcy. As a last resort, borrowers should consult with a seasoned bankruptcy attorney.
Can I negotiate with creditors myself?
Yes, negotiating directly with creditors is an option, especially if a credit counselor advises that bankruptcy is not necessary. Direct negotiation can save costs and potentially lead to favorable repayment terms.
What if my debt is overwhelming and bankruptcy seems like the only option?
Even in severe cases, options like debt consolidation loans or rigorous budget adjustments can provide sufficient relief. But, if all else fails, bankruptcy can be the best course of action to provide the relief you need.
The Bottom Line
Choosing an alternative to bankruptcy is a proactive step toward maintaining your financial health. While bankruptcy might seem like a quick fix, the alternatives discussed here can mitigate the negative impacts on your credit report and set you up for long-term financial stability.
If you’re navigating these complex decisions, consider consulting with JVM Lending. With expert advice and tailored financial solutions, JVM Lending can assist you in managing your debts effectively without the severe repercussions of bankruptcy. Remember, the path to financial recovery often begins with a single, well-informed step forward.
If you need more information about how to manage your mortgage during your bankruptcy, contact JVM Lending at (855) 855-4491 or email [email protected].
