Debt Relief vs. Bankruptcy: What’s Right for You?
- Debt relief or bankruptcy can both help you get rid of debt faster.
- Bankruptcy is a public procedure that requires a court filing.
- Debt relief (debt settlement) is a private process between borrowers and creditors.
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If your money problems are severe and you can’t afford your debt payments, you’re probably considering debt relief or bankruptcy. Debt settlement and bankruptcy are both drastic solutions for big money problems, and they can both reduce debt balances. When weighing debt relief vs. bankruptcy, you’ll look at four factors: privacy, control, tax consequences, and cost.
Debt Relief vs. Bankruptcy Definitions
What is debt relief? What is bankruptcy? They can accomplish the same thing, but they work very differently. Understanding the differences will help you decide which is better: bankruptcy or debt relief.
Chapter 13 and Chapter 7 bankruptcy
A bankruptcy filing is a formal request to a bankruptcy judge for protection from creditors. In this request, you indicate why you cannot repay your accounts and provide a list of creditors. You also supply proof of income and a list of assets. Be truthful and thorough.
You have to pay bankruptcy filing fees, which are just under $350 as of this writing. You’ll also have to complete pre-bankruptcy credit counseling and a debtor education course. Total fees for those are about $100. If you hire an attorney, you’ll need to factor in that cost as well.
The bankruptcy judge decides what assets you must give up (Chapter 7) or how much income you must pay each month (Chapter 13). Your county clerk’s office records the filing, and anyone can view this record. Once you file, your creditors suspend collection attempts.
What is Chapter 7 bankruptcy?
Chapter 7 is called liquidation bankruptcy because the court takes your assets, sells them, and distributes the proceeds to your unsecured creditors. Your creditors have to accept whatever the court gets from you as payment in full. Chapter 7 bankruptcies typically conclude in just a few months, so if a judge grants your petition, you can discharge your unsecured debts quickly.
However, Chapter 7 is only available to you if you pass a “means test.” You pass a means test if your income is too low to pay anything to your creditors. If you fail the means test, bankruptcy law will not allow you to file Chapter 7.
Chapter 7 bankruptcy remains on your credit report for up to 10 years from the filing date. Filing has a dramatic harmful impact on your credit score. Over time, the effect on your credit score lessens.
What is Chapter 13 bankruptcy?
Chapter 13 is the reorganization bankruptcy. With Chapter 13, the bankruptcy judge or trustee examines your income and debts and determines an amount you can afford to pay each month for three to five years. This amount may take all of your discretionary income – Chapter 13 is not meant to be easy.
If your monthly income is less than the state median income for your household size, you pay for three years. Otherwise, it’s five years. Every year, you’ll submit tax returns. The trustee may adjust your payment if your income changes.
At the end of your term, if you’ve made your payments on time and in full, the trustee discharges the remaining balances on your accounts. Debt discharged in bankruptcy is usually not taxable income, according to the IRS.
How Does Debt Relief Work?
Debt relief (aka debt settlement) is similar to bankruptcy in that it can allow you to zero out unsecured debt for less than the amount owed. With debt relief, you offer your creditors a lump sum that’s less than what you owe them and ask them to consider your account paid in full. Many consumers hire debt settlement companies to help them negotiate with creditors.
Usually, creditors don’t accept a settlement offer if they believe you can afford to pay the entire balance. So consumers who settle debt typically stop making payments on the accounts they hope to settle. Instead, they put those payments into a debt settlement savings account. Once you begin missing payments, your creditors will probably start contacting you about your accounts. This may get very aggressive, depending on who you owe and your state laws governing debt collection.
After (typically) about four months, you may begin the negotiation process. And over time, you or your debt relief company can negotiate and settle one by one with your unsecured creditors. You can speed up the process if you save more each month or find a way to borrow a lump sum to offer – perhaps by borrowing against a 401(k) account or from a family member. Debt settlement takes typically about two to four years to complete. There is no public filing when you settle debt because you do it outside the court system.
With debt relief, forgiven amounts are taxable unless you’re insolvent. According to the IRS, being insolvent means your debts are greater than your assets. Debt relief can show up on your credit report in two ways – when you miss payments to your creditors, and when they close your account and accept less than the full amount due. This can impact your credit scores for up to seven years, although the effect diminishes over time.
Pros and Cons: Debt Relief vs. Bankruptcy
Here are the pros and cons of each bankruptcy option and a debt relief solution.
Debt relief pros and cons
Debt relief pros:
Debt relief is private. No one ever needs to know about your debt problems.
You remain in control. You only settle when the offer is acceptable to you.
You protect your assets. No one can force you to surrender anything or pay more than you want into a plan.
Debt relief does less harm to credit scores than bankruptcy, and you usually recover sooner.
Debt relief can result in substantial debt reduction.
Debt relief cons:
Creditors may contact you aggressively. Whether you can legally make them stop depends on the state in which you live.
Your creditors do not have to negotiate with you. They can even choose to sue you.
Forgiven amounts are taxable if you are not insolvent.
Bankruptcy pros and cons
If you qualify for Chapter 7, you can resolve your unsecured debts in just a few months.
Creditors cannot opt out; they must accept the court’s rulings.
You can get out of all (Chapter 7) or some (Chapter 13) of your unsecured debt.
Forgiven amounts are usually not taxable.
Creditors have to stop trying to collect on your debts after you file.
Bankruptcy is public. You cannot protect your privacy when you file.
Filing bankruptcy gives control to a judge or trustee. This person can take your non-exempt assets (Chapter 7) or your discretionary income (Chapter 13), and it's not negotiable.
Chapter 13 bankruptcy can take up to five years and you could end up paying everything you owe.
Bankruptcy usually has a greater negative effect on credit scores than debt settlement.
Bankruptcy can make you ineligible for most mortgages and some jobs for years.
Summary: Debt Relief vs. Bankruptcy
Here’s a quick rundown of the meaningful differences between debt relief and bankruptcy:
Privacy: Debt settlement is private, while bankruptcy creates a public record.
Taxes: Amounts forgiven in debt settlement are taxable unless you are insolvent. Amounts discharged in bankruptcy are not usually taxable.
Time: Chapter 7 bankruptcy is the fastest option. Debt relief typically ranges from 24 to 48 months. Chapter 13 filers usually pay for three or five years. However, most filers get five-year plans.
Cost: DIY debt settlement may cost nothing, while debt relief companies charge between 15% and 25% of the enrolled balances. DIY bankruptcy filing costs between $350 and $450; Chapter 7 with an attorney runs $1,500 to $3,000 and Chapter 13 with an attorney costs $3,000 to $4,000.
Credit Score: The effect on your credit score depends on how good it is to start with. If you’re already missing payments, the impact will be much less than if you’re starting with a 700+ score. While both solutions can devastate credit scores, bankruptcy does more harm, and recovery takes longer.
So deciding whether to go with debt relief or bankruptcy depends on which of these factors is most important to you.
Which Is Better: Bankruptcy or Debt Relief?
When considering debt relief vs. bankruptcy, ask yourself these questions:
How much unsecured debt do I have? If you have a huge amount of debt relative to your assets, bankruptcy with a lawyer can be less expensive than professional debt settlement.
Would it upset me if anyone could see that I’d filed bankruptcy? Debt settlement is the better choice if your privacy is the top concern.
Am I comfortable going into court and dealing with filing requirements? Bankruptcy court can be stressful, and the process is complicated. You must handle filing yourself or you’ll need an attorney’s help.
Would a bankruptcy disqualify me for jobs or promotions in my field? If bankruptcy filing cancels your career, it’s probably not an option.
Would it bother me if my creditors called me about late payments? Debt settlement can be stressful if your state law allows creditors to contact you aggressively.
Do I have assets that I want to protect? Only Chapter 13 bankruptcy and debt relief allow you to keep your assets.
Can I pass a means test? Chapter 7 is only available if you can pass a means test. Chapter 13 bankruptcy requires you to repay some or all of your unsecured debt.
Do I qualify as insolvent? If your liabilities exceed your assets after debt settlement, you won’t owe taxes on forgiven amounts. That can be a major factor when deciding on debt relief vs. bankruptcy.
What is my tax bracket? Your tax bracket matters if you won’t be insolvent after debt settlement because it determines how much tax you’d owe on forgiven debt. That’s important when weighing debt relief or bankruptcy.
Once you answer those questions, the debt relief vs. bankruptcy decision becomes clear.