Eliminating Debt: Settlement, Consumer Proposal, Bankruptcy

Consolidation loans rarely work in practice.

Due to bad credit and elevated debt level relative to income, most lenders are redundant to take the risk on you. This unless they charge you very high interest rates – usually worse than credit cards. Fairstone and sub-prime lenders come to mind. It is not unheard of to see 30-50% APR, before extra fees. As result, you’ll end up paying even more.

Increasing Credit Score from Debt Consolidation Loan

However, depending on how the consolidation loan is structured, your credit score may increase. Credit scores decrease with increasing debt utilization ratios of revolving credit (e.g. lines of credit, credit cards; debts where you can choose to use a certain portion of what’s available).

So suppose you have $20,000 of Visa debt and that is also the credit limit of your Visa(s). You rolled it over to a $20,000 loan with a fixed 36 month term. This is an instalment loan rather than revolving credit with some $X limit and $Y usage, so your credit score should gradually increase. Lenders will see it as some term loan versus maxed out credit card(s).

Debt Settlement

Alternatively, you can tell your creditors that you’re considering an insolvency proceeding (e.g. bankrupt) and you can offer to settle the debts today for some $X amount. This has to be done correctly, especially by making sure you read all the fine print of whatever agreement you generate. Reduced repayment rates of 50% have been heard of, but it is a case-by-case basis. This is like playing chess, as the creditors see options like:

They Hire a Collections Agency

Typical Collections Agencies function on contingency (commission of collected money); 20-30% rates are common. So the creditor can potentially recover 70-80% of the debt.

They Sue for the Debt.

The average 2-day civil trial costs a bit over $30,000 in legal fees. To attend a hearing, usually $5,000+. To file a proceeding: seen anywhere from $1,000-2,000+. Add another $100-200+ for a Process Server to serve you, which can dramatically rise if you are very difficult to locate. The creditors would claim their legal fees against you – but – if you dispute the claim and even if they win, on a good one they’d be lucky to see 30-40% of their legal fees rewarded.

Then even if they win, they have to undergo the Enforcement process (filing, then seizure and/or income garnishment).

So in reality, unless the debt is in excess of $10,000-15,000 – and you actually have assets recoverable, creditors likely won’t sue you.

Collections actions very likely will happen, given the agencies only get paid when they collect successfully. This can turn into annoying harassing phone calls on a daily basis. But if you simply don’t pay them, then their alternative is to give up or sue.

Much of the time creditors will try to “work with you”, such as reducing interest or payments temporarily. This in hopes to avoid costly collections actions, litigation, and/or destroying a previously good relationship with you and sacrificing their reputation.

Debt settlement also is the least credit-damaging avenue to settle the debt for a reduced amount. But, you don’t have the legal protection other options offer; banks can still try to pursue you for outstanding debt.

The alternatives to debt settlement are the government-sponsored orderly payment of debts program, or insolvency: consumer proposal or bankruptcy.

Orderly Payments of Debt Program

Once arranged, creditors can’t pursue you for anything else.

Your outstanding debt is converted into up to a 5-year 0% loan.

Your credit is crushed to a R7 Rating (worst next to bankruptcy) while you’re repaying the loan, plus 2 years after.

This is not really worth it unless you’re looking to get out of very high interest rates and want to take up to 5 years to repay the debt. Or, you don’t want a public record of this for the rest of your life – a consequence of the alternatives: a Consumer Proposal or Bankruptcy.

Consumer Proposal

This is a more formal, legal version of settlement where a Stay or Proceedings is filed. It blocks creditors from taking legal action against you. Any wage garnishments and other related proceedings are stopped.

Basically you’re paying back only some X% of your debt over up to 5 years. Filed only by a licensed insolvency trustee, it is in effect if more than 50% of your debt holders accepts the proposal, or 45 days have passed with no response. This 50% proportion is based on how much debt each creditor holds.

For example, if you owe $55,000 to creditor A and $45,000 to 5 others: the proposal is in effect if A says yes.

Your credit is crushed for 3 years after you’re done paying off the Proposal.

The trustee filing for you takes his or her share in fees, set by a government tariffs. In Alberta it starts at around $1,500 + 20% of your settlement amount, but varies depending on some factors.

There also is a permanent public record of you filing one, even after it disappears off your credit report.

What affects the chance of having the Consumer Proposal working? It looking better than if you were to go bankrupt, by a reasonable margin. Usually creditors want to see a recovery rate of 10% or more versus a bankruptcy scenario.

Basically:

Settlement + t > m(i – $2,200)/2 + assets – liabilities on assets

Where:

• Assets and liabilities on assets exclude property with $40,000 equity or less, or a vehicle with equity of $5,000 or less
• Liabilities on assets: money owed on assets, such as vehicle loan or other secured debts
• i = Monthly income $2,200 or higher
• m = Months; 9-21. For those who make “surplus income”; above $2,200/month, usually this is 21 months. In a bankruptcy, for this period, the debtor is required to pay back 50% of income exceeding $2,200/month
• t = trustee fees. Usually $1,500 + 20% of settlement (excluding itself), varying upon province and income level, and set by a government tariff
• Settlement: the funds available to creditors.

This is true as in a bankruptcy, creditors receive half of your income above $2,200/month, for 9-21 months – longer if it is not your first bankruptcy. They also receive any assets you have, minus debt you owe on them. A home with $40,000 equity or less in it, or a vehicle $5,000 or less equity or value, are exempt.

What’s reasonable varies upon creditors. Many accept a settlement about 10% better than what they’d recover in a bankruptcy. This represents the risk premium they like to offset the risk you will default on your payments, and going through the trouble of making the arrangement.

Each creditor is different. For smaller debts less than $10,000, most creditors don’t even bother taking legal action to encourage people seeking the protection of an insolvency proceeding. The debtors just won’t pay them at all. Many debtors just have no money to begin with. Those creditors may just take what they can get.

They also know most people don’t want to actually go bankrupt. There’s also a chance things will get better and you’ll run into money – money that they can go after.

Creditors generally become tougher with larger amounts of debts.

The courts generally are harder on those who make higher income above $2,200/month, for obvious reasons, so their income garnishment is expected to be closer to 21 months.

Younger people are generally also expected to have less commitments, greater ease of finding income, and live longer to get their lives back on track, hence longer bankruptcy periods.

Age and income level hence, are factors that’d affect how much of a risk premium the creditors want embedded in the Settlement. This for forgoing potentially more or similar money they may get in a bankruptcy. However, for those earning not much more than $2,200/month, these factors are less significant.

Notwithstanding the likelihood to be paying back income for longer than 9 months: they also factor in a risk of you losing your income as well.

More on this in the next section: Bankruptcy.

Example Consumer vs. Bankruptcy Scenario

• Income: $4,000/month
• Assets: $1,000 cash
• Unsecured debt looking to abolish: $40,000

Settlement + t > 21($4,000 – 2,200)/2 + $1,000

Settlement + t > $19,900

t: $1,500 + 0.2($19,900) = $5,480

Settlement available to creditors: $14,420

Recovery rate in a bankruptcy: 36.1%

For this debtor, he/she had a chance of filing a successful Consumer Proposal if he/she offers a recovery rate exceeding another 10%; 46.1%: $18,400; 46.1 cents on the dollar.

Adding the trustee fees, this would be a total of $23,880 ($398/mo.) out of $40,000 he/she would spend. He/she saves $16,180 and there would be no more buildup of interest and fees, or harassing phone calls and letters.

However, in both above scenarios, he/she would have to pay $900/month in a bankruptcy of 9-21 months: half of the income excess of $2,200/month.

Example Where Consumer Proposal Doesn’t Work

• Income: $8,000/mo.
• m = 21 months
• Assets: $0
• Unsecured debt: $60,000

Settlement + t > 21($8,000 – 2,200)/2

Settlement + t > $60,900

t = $1,500 + 0.2($60,900) = $13,680

Settlement = $47,220; 79% recovery by creditors

Consumer Proposal: offer 89% to creditors; $53,400

t then becomes 0.2($53,400) + $1,500 = $12,180;

Total cost to debtor: $53,400 + 12,180 = $65,580; higher than the original debt of $60,000!

In this scenario, a Consumer Proposal would actually cost more than the original debt, after factoring in the trustee fees and what the creditors would receive in a bankruptcy! Debt settlement is more advantageous – though most people in such a situation wouldn’t have the cash laying around anyway. This debtor then has 2 rational solutions:

(A) Working with the creditors to reduce interest rates or principal;

(B) Government-sponsored Orderly Payment of Debt Program: paying back original debt of $60,000 with no interest and still benefiting from stopping all creditor action.

Bankruptcy: The Most Powerful Solution

A Stay of Proceedings is filed, blocking creditors from pursuing you.

The insolvency trustee takes all your assets, except property where you have $40,000 of equity or less, or a vehicle with equity at $5,000 or less.

Assets are auctioned off if applicable, and then the remains distributed to your creditors in a particular order.

You cannot be a director of a company (i.e. you can’t have a corporation or lead one) or obtain credit while you’re bankrupt.

For 9-21 months, you’re bankrupt. Income in excess of $2,200/month is 50% taken away and paid to the creditors.

If you’ve been bankrupt before, this increases to 24-36 months.

You’ll have to go to mandatory debt counselling and have your finances monitored aggressively. After 9-21 months, you’re discharged from all debts given you’ve done what you’re supposed to do. Now you’re set free.

For 7 years after: your credit is crushed. This becomes 14 years if you’ve went bankrupt before.

There is also a permanent public record of you filing for bankruptcy. Some jobs don’t hire anyone who has gone bankrupt, such as becoming an insolvency trustee (Haha), a “responsible” lawyer or accountant, and other odd positions of high financial responsibility.

The trustee charges a fee equal to some government-mandated amount.

One question you may ask then is: when is the Consumer Proposal or bankruptcy most effective for getting rid of debt?

• Those who are in such horrific amounts of debt coupled with income $2,200/month or less – that there is no realistic scenario they’d service the debt otherwise.
• They are being harassed daily multiple times by creditors calling.
• They are being taken to court.

But, they still got enough money and/or surplus income to at least pay the trustee for his/her service. If the creditors discover this surplus income or leftover money exists, then they’d garnish and/or seize it through litigation. Hence the existence of the Stay in Proceedings mechanism.

The system is in place obviously to protect the most vulnerable members of society. This to let them start over and get back up on the feet. That way, they can be a net economic contributor to society again.