If you’re dealing with more debt than you’re able to pay off on your own, both debt settlement and bankruptcy could help eliminate your debt and get your finances back on track.
But which of these options is right for you? The answer depends on many factors, including how much you owe, how much you can afford to pay, and how quickly you want to get out of debt.
Before you commit to either of these options, it’s critical that you research the pros and cons of each one to make sure you’re choosing the right one for you.
Debt Settlement vs. Bankruptcy: Pros and Cons
|Savings||Could significantly reduce your debt||Could discharge your debt entirely|
|Time||24-60 months|| 3-4 months (Chapter 7) |
36-60 months (Chapter 13)
|Cost||Could cost less per month than your current minimum payments||Could cost $500-$6,000 in legal fees|
|Credit Impact||Remains on your credit report for 7 years|
Temporarily lowers your credit score
|Remains on your credit report for 7-10 years |
Drastically lowers your credit score
|Drawbacks||You may be contacted by debt collectors and risk legal action |
You may have to pay 15-25% of your enrolled debt in debt settlement fees
|You may risk losing your assets, including your home |
You’re required to attend a federal court hearing
You must attend credit counseling a
|Other Associated Fess||You may have to pay taxes on your settled debt||You may have to pay and up to $335 in filing fees|
Before you decide on bankruptcy or debt settlement, you should understand how each process works and who qualifies so you can make an informed decision about how to deal with your debt.
What Is Debt Settlement?
Debt settlement is a process where you or a company working on your behalf negotiates with your creditors to lower the amount of debt you owe. The new lowered amount is called a settlement. It may sound strange that creditors would accept less than they’re owed, but the practice of debt settlement has been around for decades.
If you’re able to demonstrate that you can’t pay the full amount you currently owe, debt collectors are often willing to settle for less just so they can get something out of the deal. They also know that if you file for bankruptcy, it would eliminate their ability to collect any money from you at all, so debt settlement is sometimes the best available option for both debtors and creditors.
If you’re struggling with a massive amount of credit card, personal loan, or medical debt, debt settlement could help you:
- Significantly reduce what you owe and save money on your debt
- Get out of debt in 24-60 months, depending on the debt settlement company you work with
- Pay less each month than you’re currently making in minimum payments
Before you move forward with this option, though, you should understand the in’s and out’s of debt settlement.
How Debt Settlement Works
The first step in debt settlement is to stop making payments to your creditors and start saving into a separate account that you will use to pay your settlements with your creditors.
Not only does going past due make it easier to save money, it also gives you leverage when you or the company you work with negotiates with your creditors. After all, if a creditor is still collecting money for you, they have no reason to negotiate.
Not paying your creditors could have negative side effects, too. To try to collect on the debt, your creditors may start calling you or could even take legal action against you. They will also report to credit bureaus that you are delinquent on your payments, which could negatively impact your credit score.
After you’ve saved up a substantial amount of money, you or the company you work with will negotiate a settlement with your creditors. If you are working with a debt relief company, they will help to negotiate a settlement that you will approve. Depending on the agreement both sides come to, you’ll settle your new lowered debt with a large lump sum payment from your saved money, or pay it off according to a structured settlement plan.
For many people the benefits of getting out of debt for less outweigh the negative impact that debt settlement could have. However, before you enroll in a debt settlement program, you should make sure you qualify for this debt relief option.
Who Qualifies for Debt Settlement?
If you want to get out of debt faster and for significantly less than what you owe, debt settlement could be a good choice for you. Here’s how to tell if you qualify for debt settlement:
- You’re struggling to pay off $7,500 or more in debt.
- Your debt is unsecured, meaning that it is not tied to any assets. This includes debt from credit cards, personal loans, medical expenses, certain business expenses, and private student loans.
- You have experienced a financial hardship, like job loss, divorce, death of a spouse, medical bills, or other unexpected expense that caused you to get into debt and/or is preventing you from paying off your debt.
- You can afford to pay some, but not all, of your outstanding debt.
- You want to avoid declaring bankruptcy.
Many people choose debt settlement over bankruptcy because they want to avoid a potentially lengthy legal process and long-term damage to their credit, or they are confident they can save more money with a settlement. While there is a stigma attached to bankruptcy, it is still important to understand that it is a legitimate option if you are overwhelmed with debt.
What Is Bankruptcy?
Bankruptcy is often seen as the last resort when dealing with unmanageable debt. Bankruptcy is a legal process, where a court will discharge your debts and allow you to settle them as part of a new agreement.
During the bankruptcy process, you will first undergo mandatory credit counseling with an organization approved by the federal government. Over the course of an hour or so—in person, online, or over the phone—the credit counselor will review your personal finances, discuss alternatives to bankruptcy, and help you develop a personal budget plan.
After counseling, you or your lawyer will submit a petition to a bankruptcy court within the next 180 days and attend a hearing with your creditors to address any objections they may have. You are not required to hire a lawyer for bankruptcy, but it is strongly recommended in order to navigate the legal complexities of bankruptcy and to increase your chances of a successful bankruptcy case.
After declaring bankruptcy, creditors will be legally barred from collecting on outstanding debts, and a lawyer will help protect you against penalties and will put your interests first. After coming to an agreement, you will repay your creditors either with assets or on a newly structured repayment plan, and finally undergo post-bankruptcy credit counseling.
There are two types of bankruptcy for individuals: Chapter 7 and Chapter 13.
Chapter 7 Bankruptcy
The most common type of bankruptcy, Chapter 7 bankruptcy allows you to discharge unsecured debt in exchange for liquidating, or selling off, your assets. Depending on the laws in your state, you may end up selling off your home, vehicle, family heirlooms, or other valuable assets in Chapter 7 bankruptcy.
If you have very few valuable assets, or if the bankruptcy laws in your state protect your most important assets like your home, declaring Chapter 7 bankruptcy may be a good option for eliminating debt. The process typically takes from three to six months, after which your qualified debt is cleared and you no longer need to make any payments.
As long as you are able to demonstrate in a court that you are unable to pay, almost all debts can be discharged in a Chapter 7 bankruptcy. Nearly all individuals who qualify and file for Chapter 7 bankruptcy are successful in getting their debts discharged.
You cannot be earning more than the median household income in your state and qualify for Chapter 7 bankruptcy. If your income is greater, you may want to declare Chapter 13 bankruptcy instead.
Chapter 13 Bankruptcy
With Chapter 13 bankruptcy, you’ll restructure your debt and pay it off over three to five years. Unlike Chapter 7, Chapter 13 bankruptcy will allow you to pay off some secured debt, such as overdue mortgage payments. You will also be able to keep your assets if you choose Chapter 13 bankruptcy.
Chapter 13 bankruptcy is typically referred to as “wage earner’s bankruptcy” because it is used by individuals with a significant regular income. This type of bankruptcy can discharge secured debts less than $1,184,200. Secured debts include those backed by assets, such as mortgages and vehicle loans. Chapter 13 can also eliminate unsecured debts such as credit card debt of less than $394,725.
The length of your repayment plan and the amount are dependent on your income and the value of your non-exempt property. If you don’t keep up with payments, you could risk losing your assets. Once the payment plan is complete, your debts will be considered settled. If you are unable to stick to your payment plan, your debts will not be discharged and you may end up in a bigger mess than you were already.
Who Qualifies for Bankruptcy?
If you’re wondering if you qualify for bankruptcy, there are a couple things you should know.
- There is no debt minimum for bankruptcy, but you must be able to pass a “means test” to determine if your income is low enough to qualify for Chapter 7 bankruptcy.
- You will have to demonstrate your financial insolvency, or inability to pay off debts in order to qualify for Chapter 7 or Chapter 13 bankruptcy.
- If you have a high income or many valuable assets qualify, you may qualify for Chapter 13 bankruptcy, which doesn’t require a means test.
Bankruptcy allows you to get a fresh start and to eliminate debt, but it will profoundly affect your credit. A Chapter 7 bankruptcy will remain on your credit report for ten years after filing, and a Chapter 13 bankruptcy will remain on your credit report for seven years. Both types of bankruptcy come with associated borrowing restrictions.
To find out if this is the right solution for you, you can learn more about bankruptcy.
Which Solution Should You Choose?
As with any debt solution, there are pros and cons to both debt settlement and bankruptcy. Which option you should choose depends on your unique financial situation.
While debt settlement remains on your credit report for seven years, it could have less of a negative impact on your credit score than bankruptcy. This option allows you to get out of debt without risking your assets, and it could cost you less than you’re paying right now in minimum payments. Many people choose this option because they still want to pay their creditors back for what they owe, but their debt has gotten so out of control that it’s impossible to pay them back in full.
On the other hand, bankruptcy may be a good if you have so much debt that you will never be able to pay it back. This is considered the nuclear option when it comes to getting out of debt—but sometimes it’s the only way to wipe the slate clean. If you still have questions about whether bankruptcy or debt settlement is a better option for you, request a free consultation with one of our Certified Debt Consultants. They’ll walk you through all of your debt relief options, answer your questions, and help you figure out what to do next.