Understanding Debt Restructuring
If you’re struggling under the weight of your debt, you may have heard of debt restructuring as a way to get some relief. You may have even heard that you can get some of your debt forgiven through the debt restructuring process, allowing you to get a fresh start.
But what exactly is debt restructuring and how does it compare with other debt relief options? This article breaks it all down so you can decide whether restructuring your debt is a wise decision for you.
What is debt restructuring?
Debt restructuring can take several different forms, but at its core, it is simply the process of changing the terms of an existing loan, typically in order to make it easier for the borrower to pay back some or all of the debt.
A debt can be restructured to lower the interest rate, extend the repayment period (consequently lowering the monthly payment), forgive some of the balance owed or otherwise change the terms and conditions of the loan.
Bankruptcy is one route to restructuring debt. Cathy Moran, a certified bankruptcy specialist who practices in the San Francisco Bay Area and runs the website bankruptcysoapbox.com, says that Chapter 13 bankruptcy can be an attractive option because you know going in which debts will be discharged and which won’t, it provides protection from creditors while you make payments, and in the end it can offer a lot of relief by wiping the slate clean.
But bankruptcy isn’t the only option. Consumers can also restructure their debt by reaching out to their lenders directly. If you can demonstrate financial difficulty, lenders may be willing to negotiate with you in order to recoup more of the loan balance than they would get if you default or go bankrupt.
Jay Fleischman, a consumer bankruptcy attorney practicing with Consumer Help Central in Los Angeles says that restructuring your debt outside of bankruptcy can be a good idea if you have just a few creditors, but can be difficult if you have to negotiate separate deals with multiple lenders. He also cautions that you typically have to be seriously delinquent in order for lenders to negotiate with you, since they need to see that they’re at a real risk of losing money.
Before moving forward with any debt restructuring, it’s a good idea to consult with an experienced credit counselor who can help you understand your situation, evaluate your options and create a plan that puts your interests at the forefront. But you do need to be careful: The debt counseling industry is rife with scams.
The National Foundation for Credit Counseling is a nonprofit organization that can connect you with credit counselors and other resources to help you through this process.
When is it smart to restructure debt?
Debt restructuring can provide some financial relief, but it also comes with a number of negative consequences; these include a hit to your credit score, a potential increase in taxes and possibly larger interest costs over time.
It’s always worth evaluating all your options before moving forward with debt restructuring. Refinancing, debt consolidation, stricter budgeting and selling some of your personal property are all alternatives to a debt restructuring that can make more sense in certain situations.
But Moran provides two examples of situations in which restructuring your debt, particularly through bankruptcy, can be the right move.
The first is if you’re approaching retirement age without any retirement savings and your monthly debt payments prohibit you from making any progress. In that situation, getting relief from your debt can allow you to direct that money toward retirement accounts instead.
The second scenario: If you have a number of debts that won’t be discharged in bankruptcy — such as recent taxes, student loans, and child support or alimony — but your other debts are preventing you from paying them down. In that case, having your other debt discharged can make it easier to pay off those priority debts so you can get on with your life.
Whatever the particulars of your situation, Moran encourages consultation with a qualified bankruptcy attorney as soon as possible.
“I see too many people struggle for too long and make bad decisions, either because they’re dealing with bad assumptions about bankruptcy or because of some kind of emotional resistance,” Moran says. “Meeting with a bankruptcy lawyer doesn’t commit you to a filing, but a good lawyer will help you evaluate your options and create a plan that works for you.”
She suggests using the search tool available through the National Association of Consumer Bankruptcy Attorneys to find a practitioner in your area. She also provides guidance on how to interview attorneys here.
Benefits of debt restructuring
While restructuring your debt is not a cure-all, there are some good reasons to consider it.
Here are the main potential benefits:
- Protection: Moran says one of the main benefits of Chapter 13 bankruptcy is the protection you get from creditors. Filing a petition for Chapter 13 bankruptcy grants an automatic stay against collection agencies and foreclosure, and all payments are made through a bankruptcy trustee, meaning you don’t have to have any contact with your creditors during the repayment period.
- Payment relief: You may be able to decrease your monthly payment, which can make it easier to stay current on your debt while still being able to afford necessary living expenses.
- Forgiveness: You may be able to have some of your debt forgiven, either by settling with lenders on your own or by having some of your debt discharged through Chapter 13. Moran notes that any debt that is forgiven privately is counted as taxable income in the year it’s forgiven, while any debt that is discharged through bankruptcy is not counted as taxable income.
- As Fleishman puts it, “Chapter 13 is a good idea for people who have fallen behind on mortgages or car loans, as it allows for the curing of defaults without the threat of foreclosure or repossession”.
Risks of debt restructuring
While restructuring your debt can provide some relief while allowing you to maintain ownership over major assets like your home, there are some significant downsides to consider.
Here are the biggest risks:
- Negative impact on credit score: According to Moran, a Chapter 13 bankruptcy typically remains on your credit report for seven years from the date you file. Other types of debt restructuring that result in some of your debt being forgiven will also be reported to the credit bureaus and negatively impact your credit score
- Long-term cost: If you extend your loan repayment period, you might decrease your monthly payment, but will increase the total interest you pay over time.
- Tax impact of forgiveness: If you settle your debt outside of bankruptcy, the amount forgiven is typically counted as taxable income in the year it is received, which will increase your tax bill. This is one of the benefits of bankruptcy, Moran argues since debt that is discharged through bankruptcy is not counted as taxable income.
- Not all debts are discharged: Even bankruptcy doesn’t completely wipe the slate clean. as child support, alimony and most tax obligations must be fully paid. Secured debts, such as a mortgage and auto loan are also required to be paid 100 percent if you want to keep the property.
Understanding the debt restructuring process
If you are attempting to restructure your debt on your own, outside of bankruptcy, the process will look different from one lender to the next.
Fleischman says that lenders will generally only be willing to negotiate privately if you are seriously delinquent since they know that they are otherwise at risk of not receiving anything at all. Beyond that, he says it’s a matter of getting a handle on your budget and available assets and approaching each creditor with a suggested payment plan to begin the negotiation.
Restructuring through Chapter 13 bankruptcy has a more defined process. Here are the major steps, according to Moran and Fleischman:
- You file a petition for bankruptcy.
- You provide the court with information about your assets, debts, budget and other requested financial history.
- You create your own repayment plan and propose it to the court. Fleishman explains that repayment is done over a three-to-five-year period and that your monthly payment is based on your average income over the past six months, your necessary living expenses, your household size and the amount and types of debt you have.
- Your creditors have the opportunity to object to the plan.
- Once the repayment plan is approved, you begin making payments to the bankruptcy trustee.
- Your remaining debt is discharged at the end of your repayment period.
- The bankruptcy is removed from your credit report seven years from the date you filed your petition.
Debt restructuring versus debt consolidation
Debt consolidation is a popular alternative to debt restructuring and is one of the major options you should consider before deciding to restructure your debt.
Debt consolidation is the process of taking out a single new loan in order to pay off multiple existing loans. The idea is to get a new loan with a lower interest rate and/or longer repayment period, which provides financial relief while also simplifying things by allowing you to focus on a single loan instead of many obligations at once.
Click here to learn more about the debt consolidation options available to you, which include:
- Credit card balance transfers
- Home equity loans or lines of credit
- Personal loans
- Loans from a bank or credit union
- Borrowing from family or friends
- Borrowing from retirement accounts
So how does debt consolidation compare with restructuring? Here are some of the main points to consider:
- Debt restructuring typically has a more significant negative impact on your credit score. Consolidating your debt might result in a small, temporary drop in your credit score from the new account or from a hard inquiry on your credit report. But debt consolidation can help your credit score, as well. Because debt restructuring can involve bankruptcy or settling accounts for less than you owe, it can have a long-lasting negative effect on your credit score.
- Debt consolidation is typically a better option for people with good to excellent credit who have sufficient income to make consistent monthly payments. You can get relief and accelerate your debt paydown, all without a big hit to your credit score.
- Debt restructuring is typically only the better route when consolidation is not an option, either because of poor credit or because the borrower does not have enough income to support the required monthly payment.
- Fleischman says that consolidation is generally used for dealing with credit cards and other consumer debt, but isn’t helpful when it comes to taxes, student loans or secured debt like a mortgage or auto loan.
|Debt Restructuring vs. Debt Consolidation|
|How it impacts your credit score||How it impacts your monthly payment||Is debt forgiven?||Who it’s best for|
|Debt consolidation||Minimal short-term impact||Can be reduced if you get a lower interest rate||No||People with good to excellent credit who can make consistent monthly payments|
|Debt restructuring||Significant negative impact, potentially for years||Typically reduced, either by settling some debt, lowering interest rate or restructuring through bankruptcy||Some, yes||People who have defaulted on debts, poor credit or insufficient income to manage their existing debts|
When does debt restructuring make sense?
It is always a good idea to evaluate all of your options so that you can make an informed decision in the context of your personal situation.
But Moran says restructuring your debt, particularly through bankruptcy, is more likely to be a good idea for people who have no savings, are living paycheck to paycheck, have people who are financially dependent upon them, and are unable to make positive progress due to the burden of their monthly payments.
On the other hand, people who are young, healthy, have a moderate amount of debt and don’t have financial dependents may be better off seeking non-bankruptcy options like consolidation.
The bottom line
You have options and should consider all of them. But in the right situations, debt restructuring can be a lifesaver. With the right plan, you can reduce your monthly payment and potentially have some of your debt forgiven, allowing you to get a fresh start and make real progress toward the financial goals that are most important to you.