Comparing Debt Settlement and Bankruptcy

If you are facing overwhelming debt, you might often find yourself with two major debt relief options to get out of debt. These are debt settlement and bankruptcy. Both strategies can provide you with financial relief. However, both of these options may offer you a few distinct advantages and consequences. Bankruptcy offers a legal doorway to discharge or restructure your debts and let you have a fresh start. But it can also severely impact your credit scores and financial opportunities. On the other hand, debt settlement gives you the chance to negotiate with creditors and pay a reduced amount. But it also has a great impact on your credit and leads to tax liabilities.

So, which option to choose? There are situations when even the most intelligent minds fail to analyze which option is the most suitable one, bankruptcy or debt settlement.

Choosing between these two depends on factors like the total debt amount, the nature of your debts, your financial stability, monthly payment amount, and long-term goals. In this article, we will compare bankruptcy and debt settlement and provide you with insights to determine which option is best suited for your financial situation.

What is Debt Settlement and How it Works?

With the debt settlement method you can negotiate with your creditors and settle your outstanding unsecured debt less than what you owe. You, directly or through a debt settlement company can negotiate with the creditors and pay a lump sum amount as a settlement amount. This process can help many individuals like you who are struggling to manage their debt to pay off their debts with good savings. But remember, it may impact your credit score and the saved amount may also be taxable.

What Are The Features Of Debt Settlement?

1. Secured debts cannot be settled

• Debt settlement can only help you with unsecured debts like credit card debt, medical bills, and personal loans.
• It can never help you with secured debts like mortgages, auto loans, or student loans. The chances of getting your debts discharged are practically next to none.
• People usually go for debt settlement when they have too much of consumer debts that are hurting their credit profile and are turning out to be a menace!
• These debts include credit card debts, utility bills, payday loans, and personal loans.

2. Requires Financial Hardship

• Creditors are usually willing to negotiate if the borrower is in real financial distress (e.g., job loss, medical emergency). Without any serious financial crisis they won’t agree to settle your debts.

3. The negotiation

• The most important part of debt settlement is determining how much your debts will be reduced.
• It is always advised to seek the help of attorneys or a legal debt settlement company to help with the negotiation.
• It’s hard to make the creditors agree on a lowered debt amount, and usually the negotiation might become more of an argument!

4. Debt settlement may or may not require you to pay fees

• There’s nothing such as the cost of settlement if you do the settlement yourself.
• If you are taking help from a settlement company, then they will charge you a fee after they have settled at least one account.

5. Potential Risks

• Creditors may refuse to negotiate with you and take legal action against you.
• Settlement does not guarantee complete debt elimination. Some creditors may sell off the remaining debt balance to collection agencies.

6. Impact on Credit Score

• Once you start missing payments for settling your debts it will damage your credit.
• Settled debts are marked as "settled" instead of "paid in full" in your credit report. This will negatively affect your credit scores.

7. Tax Implications

• After successfully settling your debts into a lower amount, the forgiven portion of the debt may be considered taxable income by the IRS. So, you may have to pay taxes on the saved amount.

What is Bankruptcy?

Bankruptcy is a legal option where an individual or business manages or erases all outstanding debts if they can no longer afford to pay them. Bankruptcy has a serious impact on your credit and also may disrupt your financial life. So, you should only consider this option if you're completely out of choices.

Types of Bankruptcy

For individuals, there are two main types of bankruptcy:

• Chapter 7 Bankruptcy – This option can help you remove most of your debts, but you might lose some of your assets such as a second car or expensive jewelry, to pay off creditors.
• Chapter 13 Bankruptcy – This option allows you to keep your assets. However, you must follow a court-approved repayment plan to pay off part of your debt over a few years. Some of your debts may be forgiven through this option.

To file for these two bankruptcies you need to go through a process administered by the bankruptcy court. With the help of a certified bankruptcy attorney you can file for bankruptcy. The court will also check your income to see which type of bankruptcy you qualify for.

What Are The Features Of Chapter 7 Bankruptcy?

Chapter 7 bankruptcy, also known as "liquidation bankruptcy," is specially crafted for individuals or businesses that cannot repay their debts. Here are its main features:

• Debt Discharge – You can discharge your most unsecured debts, such as credit card balances, medical bills, and personal loans through this option. However, some debts like student loans, child support and certain taxes usually cannot be discharged.
• Asset Liquidation – The court may require you to sell some of your assets (like a second home, luxury items, or expensive vehicles) to repay creditors. However, you can keep some of your essential assets such as a primary home, necessary work tools and basic household items under exemption laws.
• Means Test Requirement – To qualify you must pass a means test. This test compares your income to the median income in your state. If your income is too high you may have to file for Chapter 13 instead.
• Fast Process – Chapter 7 is typically completed within 3 to 6 months. So, you can eliminate your debts faster through this option.
• Credit Impact – Filing for Chapter 7 bankruptcy significantly lowers your credit score and stays on your credit report for 10 years. So, when you apply for new credit to any new potential creditor it will be difficult to get it in the future.
• No Repayment Plan – Unlike Chapter 13 you will not be offered any structured repayment plan. Once the bankruptcy process is complete any remaining eligible debts of yours are discharged.
• Protection from Creditors – Once you file Chapter 7, creditors must stop collection efforts, including wage garnishments, lawsuits, and harassment. This protection is called the automatic stay.

Key Features of Chapter 13 Bankruptcy

• The repayment plan. This is the most important part of chapter 13. This repayment plan will help you to deal with your debts in an organized manner. This is a court-approved plan, and will usually provide you with 60 months time to clear your debts.
• Automatic stay. Once you file bankruptcy, this automatic stay will be activated on you, which will prevent you from getting sued by any creditor and court agreements. The automatic stay will halt any foreclosure proceedings on your mortgage. It will also stop your utilities from being cut and won’t allow evictions from the landlord’s side! It will stop wage garnishments and your over-payments of Public Benefits being taken back from you!
• It requires you to pay some fees. Chapter 13 bankruptcy has a liability that you will have to pay administrative claims in full. These will be your filing fees, the trustee's commission (Usually 3%-10% of your monthly income), and the fees of attorney!
• Secured debts are given good priority. Secured debts have collateral attached to them, and the creditor is secured in the sense that if you default on the payments, then they might take away the property.

  These debts or loans will have to be paid off in full; only the proposed repayment plan will help you organize your payments. There’s another thing you must know and that’s about your mortgage. As per the court proceedings and the judgments made by the attorneys and the trustee, your secondary mortgages can be stripped down if the current value of your home is less than the loan amount.

  Again, your overall mortgage amount can be cramped down if the loan amount exceeds your property’s current value! The same thing can also be applied to other secured debts, like car loans,...etc.

• Unsecured debts might get discharged. When you file for bankruptcy, you might be able to evade the maximum of your unsecured debts and even if you have some of them hanging around, their amounts could be reduced quite a bit. Usually, most of your credit card debts, utility bills, and other consumer debts have a huge chance of getting discharged. That means you practically have to pay nothing for them.
• You get to keep your assets. The good news is, Chapter 13 doesn’t require liquidating your assets. This means you get to keep all your property with you, and still be able to repay your debts with the help of the repayment plan as given to you!
• You can’t erase taxes and other priority claims. You will have to pay back taxes and other claims in full. Like money, you owe to your employees, alimony, child support, and other debts, say an employee benefit fund!

Why Do People Avoid Bankruptcy?

People don’t want to ruin their reputation and get a social stigma attached to their name! They also often avoid bankruptcy due to several significant factors and personal choices:

Why Bankruptcy And Debt Settlement Might Sound Similar At Times?

People confuse them because there’s one thing that both of them do at the end of the day, and that is to settle debts. But the methods are different and so are the results!

• With Chapter 13 bankruptcy, you will be provided with a repayment plan, with the help of which you will be able to come out clean from your debts.
• In Chapter 13, many of your unsecured debts will get discharged, and the amount of non-dischargeable debts will be negotiated!
• The same thing happens with a settlement, but here there won’t be any discrimination between dischargeable and non-dischargeable debts. As per the negotiation with your creditors, your debt amount will be reduced and you will pay a lump sum to clear your debts.

How Debt Settlement and Bankruptcy Affect Your Credit

The effect on your credit score is the most important deciding factor when choosing between debt settlement and bankruptcy. Both options may significantly lower your credit score, but in a different way:

1. Credit Score Impact

Debt Settlement: It will lower your credit score but usually not as severely as a bankruptcy. Creditors may report your accounts as “settled” instead of “paid in full” to the credit bureaus, leaving a negative mark. The drop depends on how much debt was settled and how late you were prior to the program.

Bankruptcy (Chapter 7 or 13): Both bankruptcy options have a severe impact on your credit score, causing an immediate drop of typically 100-200 points or more. This makes it challenging to acquire new credit, loans, a home, or even employment initially.

2. Credit Report Duration

• Debt settlement stays on your credit report for 7 years.
• Bankruptcy Chapter 7 remains for 10 years.
• Bankruptcy Chapter 13 remains for 7 years.

3. Credit Recovery Time

• After settling your debts, you can start rebuilding credit within 2-3 years by managing finances well and maintaining on-time payments.
• After bankruptcy, rebuilding takes longer, but good habits can allow approvals for secured cards and loans within 3-5 years.

4. Ability to Get Credit in the Future

Debt Settlement: You might get approved for new loans and credit cards, though initially at higher interest rates. Lenders may deny credit if they prioritize applicants with complete repayment histories.

Bankruptcy: Getting new credit immediately is highly challenging. Within 3-5 years, you may qualify for secured cards and standard credit with high rates.

Comparison Matrix - Debt Settlement vs. Bankruptcy

Which Is Better for You?

If you want to protect your credit score, choosing the debt settlement option is better, as:

• Debt settlement stays in your credit report less than bankruptcy.
• The credit score drop is comparatively lesser than bankruptcy.
• You have a stable income and can afford to pay off the settlement value.
• With this option, you can start rebuilding your credit faster.

However, bankruptcy might be a suitable option for you if:

• Your debt amount is too high to settle.
• You don't have a stable income to negotiate with the creditors.
• You need a complete financial reset with no past obligations.

How to find the best debt settlement company

Debt settlement has a bad reputation due to the increasing number of fraud companies in the market. Still, it’s not that hard to find the authentic one! Here are a few tips for choosing the right debt settlement company.

Bankruptcy works negatively in terms of the credit impact, while many more view it more positively. Many lenders openly insist that they consider credit counseling to be on par with filing Chapter 13. The consequences of credit counseling vary depending on what the credit card company reports to the credit bureaus. Some creditors will simply report as “enrolled in a debt management plan.” Other credit card companies report their cardholders as past due until they have made three consecutive payments, which will affect your credit negatively.

Loretta Kilday

Debt Relief Specialist & Spokesperson, DebtCC

Loretta Kilday, Esq., is an accomplished litigator and transactional attorney with more than 30 years of experience across debt collection, bankruptcy, and related matters. DebtConsolidationCare features her as its spokesperson and public voice. She earned her J.D. from DePaul University College of Law and a B.S. in Finance from DePaul University.