Author: Bill Bailey
In the UK, there are four main options for dealing with debt:
Debt consolidation - borrowing more money but reducing your monthly payment;
Debt management plan - reducing your monthly payments without borrowing more money;
Individual voluntary arrangement - a formal legal procedure which offers a write-off of debt after a prescribed period of time, generally, five years;
Bankruptcy - a formal legal procedure, which offers a write-off of debt after a prescribed time period of, generally, one year.
It is important to stress that there is no 'right' way to deal with a debt problem. Each option has its own set of advantages and disadvantages. And just as important, identifying the best option is as much to do with personal and family implications as with the financial issues.
Debt consolidation: How it works
Debt consolidation involves borrowing more money to repay your existing debts. The selling point is that the payments on the new loan will be less than you currently pay on your existing debts. This allows you to bring your income and expenditure back into balance, so solving your debt problem.
The problem with debt consolidation is that the reduction in monthly payments often comes at a heavy price.
Paying back your debt through a new loan over a longer period may sound good but take careful note of the figures. While the reduced monthly payment will help your budget, the calculation of how much you will have to pay back in total will be an unwelcome shock.
Also unwelcome if you are a homeowner may be the news that your consolidation loan is secured against your house - in effect, you are taking on a new mortgage (which is why these loans are often only advertised to homeowners). Fall behind on the consolidation loan payments and you risk losing your home.
Debt consolidation: things to be wary of
Watch out for debt consolidation companies who heavily sell additional insurances to accompany the loan. You may need protection against unemployment, sickness, or critical illness, but you will almost certainly get it cheaper if you buy it separately rather than bundled in.
If you fully understand the implications of what you are doing and are able to access new borrowing at a low rate of interest, debt consolidation can be an effective approach to a debt problem. But more often than not, it leads to worsening debt and sometimes even potential homelessness. If you are considering debt consolidation you must be aware of the downsides.
Debt consolidation is big business. And that means that some of the companies who offer loans are far more concerned with maximizing their profits than in ensuring that a consolidation loan is the right option for you. Watch out particularly for debt advice or debt management companies who suggest an additional loan without full consideration of other options.
A few years ago, debt consolidation loans were only available to those with flawless credit ratings. If you had current or previous arrears on your debt payments it was unlikely that you could access more borrowing. However, there is now a wide-range of companies that specialise in lending to borrowers who are 'credit impaired' or 'sub-prime'.
Of course, these companies do not do this out of the goodness of their hearts. The number of borrowers with current or past payment problems means that there is a large market for this borrowing with interest rates that are higher (sometimes much higher) than you might expect.
Remember that high interest debt consolidation loans - which are secured on your property - are a win-win for the lender. If you repay, then they benefit from the higher interest charges; if you default, they can repossess your home and get their money back early.
Debt consolidation loans can be a good option if:
You have the self-control to see debt consolidation as a 'once and for all' solution.
You use the reduction in outgoings to bring your budget back under control, pay back any future credit card spending in full each month without fail, and start saving for future unexpected or irregular costs;
You are prepared to shop around to identify the best value debt consolidation loan;
Debt consolidation loans can be unhelpful if:
You use some, or all of the debt consolidation loan for reasons other than repaying debt. If you need to borrow £10,000 to repay debt, then don't be tempted to borrow £12,000 to also pay for an impulse holiday;
You don't shop around and end up paying a high rate of interest on the debt consolidation loan;
You don't realize the implications of taking on a secured debt against your home.
Debt consolidation loans can be disastrous if:
You continue to accumulate debt after taking on the consolidation loan.
You cannot repay a secured debt consolidation loan and lose your home.
Advantages of debt consolidation:
You can reduce the total amount you pay each month on debt repayment.
Maintains your credit rating.
Disadvantages of debt consolidation:
Normally greatly increases how long it takes to repay your debts.
Often only advertised to homeowners.
Debt management plan
How it works
Any bank, finance company or credit card lender owed arrears by a consumer has the option to seek a judgment in the county court to reclaim their money. However, where you are not trying to avoid payment but are in genuine financial difficulty, the court is likely to order repayments based on your ability to pay.
The court accepts that you must first pay your 'priority' debts - these are debts where non payment would lead to the loss of your home (mortgage or rent payments); loss of an essential utility (gas, electricity, telephone, or water payments); loss of an essential item (cars or other hire purchase items); or could theoretically lead to imprisonment (magistrate court fines or council tax payments).
The court further accepts that you need to make other payments to maintain you and your family - so reasonable amounts for housekeeping, travel, clothing, and other similar items are taken into account.
What remains after this exercise is a guide to the amount of money left to repay your bank, credit card and other 'non priority' credit debts. The court will make a repayment order based on the figure but also take account of monies owed on other credit agreements. In addition, the court will freeze the interest charges so that the debt no longer increases.
The negotiation of reduced debt payments simulates the approach taken by the court. It involves producing a detailed income/expenditure schedule, showing how much 'spare' money is available after priority payments have been made and proposing a fair distribution of this money. At the same time, a request is also made for further interest charges to be frozen.
Arranging a debt management plan is something that you can do reasonably easily yourself, particularly if you use the self-help booklets available from National Debtline or your local Citizens Advice Bureau. However, it is also (unfortunately) true that the banks and card companies will sometimes respond more positively if a debt advice agency writes on your behalf.
Fee charging debt advice agenciesDebt advice agencies offer a similar debt advice service to the Citizens Advice Bureau but will also administer your reduced payments negotiated under a debt management plan. Your local CAB will often arrange for you to make reduced payments, but you will be responsible for making these payments.
The fee charging companies will also arrange that you pay your money over to them and they will pass it on. However, this additional facility comes at a price - the fee charging companies typically keep up to 15% of your regular payment as their fee and the whole of your first month's payment may also be swallowed up in administration costs.
Of course, paying somebody else to administer your payments means it takes longer to repay your debts. There is therefore little point in paying for a debt management company unless you think their service is worth it.
Advantages of debt management plans
Allows you to bring income and expenditure back into line without taking on more borrowing;
You can follow this option by yourself or with the help of a no fee charging debt advice agency.
Disadvantages of debt management plans
There is no guarantee that your creditors will accept the reduced payments and/or freeze future interest payments;
The time taken to repay your debt will increase. The time will further increase if you pay your debts through a fee-charging debt management company;
Your credit reference file will show details of the Debt Management Plan. This will affect your ability to get credit in the future.
Debt management plans can be a good option if your financial problems are caused by a temporary reduction in income and the situation will improve in the near future.
Debt management plans can be unhelpful if:
Your ability to pay your debts will not improve within 12 months.
Debt management plans can be disastrous if:
The fees taken by commercial debt management companies and the refusal of banks and credit card companies to freeze interest means that your debt steadily increases.
Individual Voluntary Arrangements
At best, an IVA can be an excellent solution for somebody faced with an overwhelming debt problem. At worst it provides a moneymaking opportunity for the increasing number of companies that advertise IVAs. You must make sure that this is a suitable option for you and that the company operating the IVA fully understand and represent your financial situation.
How It Works
A specialist insolvency adviser, called an Insolvency Practitioner, draws up a proposal for you to repay a specified amount in full repayment of your debt. The payment can be made in a lump sum or over a period of time - often up to five years. The companies owed money agree to write off any debt still outstanding once you have made the agreed payment. The amount paid under the IVA is normally calculated with reference to the amount that would be collected if you were to be made bankrupt.
There is normally no up-front fee to pay in using an Insolvency Practitioner - the costs of the IVA are written into the arrangement. But you should be aware that the costs can be high (we are talking thousands of pounds for even a simple IVA). It is vital that you understand how the costs will affect how much you will pay and the proportion of your payments that will be paid to your Insolvency Practitioner rather than to repay your debt.
Advantages of IVAs:
Allow you to repay your debt at an affordable rate over a reduced period of time. Alternatively, the IVA may be proposed on the basis that your family or friends are prepared to help meet your debts;
Offers the advantages of bankruptcy but without some of the restrictions and disadvantages.
Disadvantages of IVAs:
The costs of setting up an IVA can be surprisingly (some would say outrageously) high;
You may have to pay an upfront fee;
Defaulting on the payment arrangement can lead to bankruptcy;
The regulation of Insolvency Practitioners is fragmented and many consumer groups report situations where Insolvency Practitioners seem more interested in the fees that they earn rather than the success of the IVA;
Your credit reference file will contain details of your payment default.
IVAs can be a good option if:
You face a large debt problem and a debt management plan will involve payments over a greatly extended period;
You are faced with bankruptcy but wish to avoid the associated restrictions and disadvantages;
You identify an Insolvency Practitioner who you can trust to propose a realistic, workable, and, if appropriate, sustainable arrangement which works to the benefit of both you and the companies to whom you owe money.
IVAs can be unhelpful if you don't shop around to find an Insolvency Practitioner who understands your problems and who you feel you can trust.
IVAs can be disastrous if you agree to make regular payments that you know you won't be able to sustain.
BankruptcyBankruptcy is a formal legal process that draws a line under your debts. It involves the sale of any items of value that belong to you (but some items, such as your basic household goods will not be taken). It may also require that you make regular payments from your income if you can afford this after you have paid your essential domestic and work costs.
Bankruptcy is not an easy way out of paying your debts but it is an option to consider if you face overwhelming debt pressure and can see no possibility of being able to meet your liabilities. It is generally a more attractive option for those with few or no assets.
How bankruptcy works
Bankruptcy can be started by the person who owes money or by the firms who are waiting for missed payments. Banks and other finance companies will generally only make someone bankrupt if they think if it is financially worthwhile. However, this does not stop them threatening bankruptcy even where they know that they will not follow through. If you are being threatened with bankruptcy, you should get advice urgently (your local Citizens Advice Bureau or other free independent advice agency is a good starting point).
Once bankrupt, you are under the control of the bankruptcy trustee. They will arrange to sell items of value belonging to you (including your house if you are a homeowner and the sale value is more than your mortgage debt) and will want to discuss what regular payments you can make. The trustee has the power to examine the way you conducted your finances prior to bankruptcy, particularly if you gave away or sold assets. You are required to cooperate with the trustee.
A recent change in the law means that those experiencing bankruptcy for the first time can normally expect to be discharged after a maximum period of one year. You are then released from your debts (although you may be required to make regular payments for up to three years). You are expected to learn from your experience. People who go bankrupt again get a much tougher time.
Advantages of bankruptcy:
Limits the period over which you repay your debt;
Provides legal protection in respect of your debts;
Disadvantages of bankruptcy:
You are subject to the control of the court;
You face the loss of assets other than those necessary to satisfy your domestic needs, your tools of the trade, and vehicles you need in the course of your employment (which does not include travel to and from work);
Gas, electricity, and telephone contracts will need to be put in to the name of another adult who lives with you. If there is no other adult, you will have to change to a prepayment system or lose the service;
You cannot hold certain public offices while you have not been discharged from bankruptcy, nor can you continue as a director of a limited company;
Your access to credit will be severely restricted until you are discharged; thereafter you will pay higher rates of interest until you have re-established your credit rating;
Some debts will not be included within the bankruptcy. These include mortgage and other secured debts, magistrate court fines, debts payable after personal injury claims, and debts to the student loans company;
Any determination by the court that you have acted dishonestly or recklessly can lead to restrictions on your discharge from bankruptcy;
You will normally lose the use of your bank account and will be forced to open a 'basic' account with no overdraft and limited other facilities;
You should assume that your employer, friends, and neighbors will find out about your bankruptcy. Your bankruptcy will be publicized in the local Press and is available to anyone who wants to request information about you;
You will have to pay £475 to petition for bankruptcy.
Bankruptcy can be a good option if:
You face a substantial debt problem, few assets, and limited ability to pay your debts;
Bankruptcy can be unhelpful if:
You are attracted by the advantages without fully considering the downsides of the bankruptcy procedure and aftermath;
Bankruptcy can be disastrous if:
You have assets which will be seized by the bankruptcy trustee;
Your employment, business or personal relationships will be detrimentally affected.
Bill Bailey is a freelance financial journalist. More financial advice at http://www.schnafflehound.com/finance