Repayment, Settlement, Bankruptcy: Facing Debt from Failed Business

Dear Your Business Credit,

I closed a small business that was set up as an S corporation and sold its assets. I now have $20,000 in cash but $45,000 in credit card debt with three different banks. The cards have high interest so the balances are increasing by more than monthly payments. Should I settle the debt or file for bankruptcy? 

- Linda

Dear Linda,

It may seem like your balance is increasing faster than your payments, but, given existing consumer-protection measures to prevent this scenario, which is called negative amortization, my assumption is that you are making monthly payments so low that the balance is hardly budging. Federal guidelines issued in 2003 require issuers to set a minimum payment that eliminates a borrower's principal "over a reasonable period of time."

Whatever the particulars, it seems clear that paying off your debt has become daunting. Without knowing more details of your personal financial circumstances, it is hard to give you a complete answer to your question about whether it's better for you to settle the debt or file for bankruptcy.

Both solutions can hurt your credit, so it's best to avoid these routes if you can.

Debt settlement -- in which you negotiate to reduce the total amount you owe and the lender writes off the loss -- has a negative effect on your score and can show up on your credit report for seven years from the original delinquency date. A bankruptcy is a very negative event in your credit history. A Chapter 7 bankruptcy, the most common type of bankruptcy for individuals, will stay on your credit report for up to 10 years. A Chapter 13 bankruptcy will stay on your credit report for up to seven years. (For an extended discussion of how Chapter 7 and Chapter 13 bankruptcy work, please see my column "Finding a free bankruptcy lawyer for business, consumer debts.")

That said, you may still want to proceed with one of these options. Leslie H. Tayne, an attorney in Melville, N.Y., who advises small businesses on credit and debt, says it's best to avoid bankruptcy. "In this scenario, it certainly would seem more advantageous to the businessperson to work with a debt professional since bankruptcy can have more implications on a person's ability to take out a loan and get money for any future businesses and is likely to have a long-term damaging effect on one's credit score," she says in an email.

Just be careful if you enlist a debt settlement company to do this for you. While there are reputable firms, the debt settlement field has been plagued with bad practices and hucksters. "Make sure you do your homework in researching companies to ensure you are working with a reputable, qualified professional that you can trust," Tayne says.

If you do opt to use a company, the Federal Trade Commission recommends checking it out with your local consumer protection agency and your state attorney general's office to see if there are any complaints against it.

There is one other option: Paying down your debt. Although it may seem overwhelming at the moment, running the numbers with a debt repayment calculator may help you get a better sense of whether that's realistic. If you have a job or are married to someone who does -- or you have assets you can sell to pay down the debt -- you may not have to settle or file for bankruptcy protection.

For the sake of simplicity, let's say that on all three cards, you are paying 22.9 percent interest -- the going rate for a secured card offered by Capital One for people with damaged credit. If you put the $20,000 business sale proceeds toward your debt, you will immediately cut it down to $25,000. If you could manage monthly payments of $704 for five years on your current salary, you'd get your balance to zero. You would pay $17,200 in interest costs along the way.

If that monthly payment was too high for you, and you wanted to stretch the payments over seven years, you could get to a zero balance by paying $600 per month. However, you would pay $25,368 in interest over time.

But let's assume that your situation will get better over time. For the first year, you would still pay $704 a month, which would pay off $3,027 of your principal (plus $5,420 in interest). That would bring your balance to $21,972 by the end of the year.

If, at that point, your credit had improved and you were able to transfer your balances to a card with a 12.99 percent interest rate and continue on your five-year plan, you could lower your monthly payments to $590 per month for the remaining 48 months, with $6,317 in interest costs baked into those payments (bringing your total interest cost down to $11,727).

Your total interest payments will obviously be lower the quicker you get the debt paid off. I'd suggest using the calculator to plug in the real numbers for the cards you have, so you have a sense of the actual options available to you. You may find it empowering.

It may be painful to pay off debts for a business that didn't work out the way you wanted. But given that your credit score will have a big effect on your future purchasing power -- and potentially your employability -- anything you can do to keep yours strong will make a big difference in your quality of life.

See related: Understanding how credit card minimum payments are set, Debt pay-off choices: Less now or a lot later, Pay off debt vs. settle it: Which is better for your credit score?