Debt Settlement and Debt Consolidation are two diametrically opposite ways of dealing with existing debt. Debt Settlement is normally the payment of a reduced amount of debt in lieu of full settlement. On the other hand, debt consolidation is creating one single debt to repay several outstanding debts. The choice of either process would depend on the nature of the debt, the repaying capacity of the debtor and the outlook of the creditor/s.
Persons or companies, who are undergoing severe or unforeseen financial hardships, and who find it difficult to repay their outstanding debt under debt management plans, but are specifically interested in avoiding outright bankruptcy, normally opt for debt settlement. Under this process, the creditor agrees to waive a portion of the total outstanding debt and accepts the balance amount as full settlement. In several cases, the amount of debt being waived could be as large as half the total debt amount or even more.
The practice of debt settlement came into practice in the USA during the severe recession of the early period of the twentieth century. Financial institutions decided that recovering at least a considerable portion of the debt was wiser than allowing the debtor to resort to financial bankruptcy under Chapter 7 in the United States, thereby losing the entire debt amount. Debt waivers ranged between 25% to 50%, but sometimes amounts as high as 65% to 70% were foregone in the case of persons or companies facing serious financial crisis.
Debt Settlement Process
In a typical debt settlement process, the debtor would accumulate a portion of the debt amount before starting negotiations with the creditor. When faced with the option of recovering a substantial portion of the outstanding debt or losing the entire amount, the creditor would conclude that it is better to accept a lesser amount, rather than getting nothing. Once the agreement is reached, the debtor would pay the reduced amount and the account would be considered as settled in toto. Usually, debt settlement is applied only to unsecured loans or credit card dues. Secured loans like housing loans, vehicle loans, etc., are not taken under the purview of debt settlement, simply because the creditor can take possession of the house or the vehicle, and hope to recover a substantial amount of the debt through the sale of the house or the vehicle.
Incentives For Debtors
Debtors opt for debt settlement chiefly due to the reason that filing a bankruptcy would reflect upon their credit standing for the next several years. Further, a well-planned debt settlement would relieve them of the current debt repayment crisis that could have arisen because of unforeseen circumstances like sudden unemployment, unexpected medical expenses, reduced income or unforeseen financial burden. This kind of settlement would enable the debtor to go in for further debt arrangement, in case it was needed. However, the waived portion of the debt is usually considered as taxable income by revenue authorities.
Incentives For Creditors
Creditors choose debt settlement rather reluctantly. However, they take into account the high costs of recovering the full amount, keeping in mind the expenses that could be incurred in collection, as well as the high commissions or fees that have to be paid to third party collection agencies or attorneys. Moreover, putting severe pressure on a debtor to pay the full amount might push the debtor to file bankruptcy, in which case, the creditor stands to lose the entire amount.
When a debtor is having several debts with varying rates of interest, he might like to consolidate them into a single loan to take advantage of a fixed interest. In such cases, a third party financier is sought, who would take the responsibility of repaying the creditors, and recover the total debt in a phased manner. Several corporates resort to this debt consolidation facility due to the ease of payment to one creditor, compared to payments to multitude of creditors.
Sometimes, an unsecured loan is converted to a secured loan to obtain lower interest rates, which is also deemed as debt consolidation. A typical example is house mortgaging, for which the interest rate is usually lower than that for an unsecured loan. However, caution has to be exercised in such an attempt, because the interest rate advantage may be nullified by the longer period of mortgage loan payment. In certain cases, the debtor is even likely to end up paying more than he would have under the unsecured loan.
Chapter 11 bankruptcy
Under Chapter 7 bankruptcy, the debtor is once for all relieved from all the debts. However, corporates, which are going concerns, are normally reluctant to file for Chapter 7 bankruptcy. They opt to file for bankruptcy under Chapter 11, wherein they can stay in operation, while the reorganization is structured under the supervision of a bankruptcy court. The bankruptcy court analyzes the contractual and debt obligations of the company. The court is vested with powers to grant partial or even complete relief from the debt burden and the contractual obligations of the company. In recent years, due to the sudden surge in fuel prices, several American air carriers filed for bankruptcy under Chapter 11. Their main aim was to get relief from the high wages of their personnel, which sometimes were more than half of their operating costs.
However, there is a risk involved in this process of debt consolidation. If the total debts and obligations of the concern exceed the total assets, the owners of the company, namely the stockholders, stand to lose everything, with the creditors getting the ownership of the company after reorganization.
From the above discussion, it is clear that a debtor can opt for a debt settlement or for a debt consolidation. He can even take recourse to file for bankruptcy under Chapter 7 or under Chapter 11. The pros and cons of each process have to be carefully analyzed and a judicial decision that best suits the debtor has to be arrived at.