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Debt Settlement Vs Bankruptcy – Which is Best for You?

Last updated 03/19/2024 by

Andrew Latham
Debt settlement vs. Bankruptcy, which would you prefer? Both debt relief options have their pros and cons. Neither option is an ideal method to get out of debt. However, if you have exhausted all options to resolve your debt problem, both options can help you get out of debt and begin rebuilding your credit history, eventually.
If you have tried to qualify for all available debt consolidation loan options, can’t afford your loan payments, a debt settlement program or bankruptcy may be your best option. As distasteful as debt settlement and bankruptcy may be, there are times when they are the only debt relief options available. Which is best for you will depend on your financial situation and personal preferences.

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Debt settlement vs. bankruptcy: so which debt relief route is best?

To answer the question about debt settlement vs. bankruptcy, we will determine the pros and cons of these options to fend off your debt collector in four categories.
  • Potential for debt discharge.
  • Eligibility.
  • Damage to credit scores.
  • Cost.
But before we dive into the specific benefits and disadvantages, let’s get some basic definitions out of the way.

What is debt settlement?

A debt settlement is a debt relief program typically offered by a debt resolution company. The debt settlement companies negotiate a lump sum payment to creditors instead of the full amount you owe. It only works with unsecured loans. There are pros and cons of debt settlement. To qualify for debt settlement, you must stop making payments to unsecured creditors. Instead, you make deposits into a settlement account. Once there is enough money in the account, the debt resolution company negotiates a reduced payment with your creditors.
Consumers should be aware of the cons of a debt settlement plan. When a debt is negotiated for less than you owe, you may be subject to tax penalties for debt forgiven. When choosing between debt settlement and bankruptcy, consider your monthly payment plan, the type of debt you owe, and the risks.

What is bankruptcy?

Bankruptcy is a legal process by which individuals and businesses can eliminate or repay debt under the federal bankruptcy court’s protection. There are two types of bankruptcies: liquidation and reorganization.
Chapter 7 is the classic liquidation bankruptcy. As its name implies, it requires debtors to liquidate or sell their property to pay some of their debt. However, some types of property are protected by state and federal bankruptcy laws. In some instances, debtors may have little to pay once state exceptions (i.e., protected property) are applied.
Chapter 13 is the most common reorganization bankruptcy. With this type of bankruptcy, debtors get to keep all, or most, of their property. However, unsecured debt is not discharged; it is reorganized into affordable payments. If a debtor completes the repayment terms, pending unsecured debt is discharged. According to researchers, only a third of debtors complete repayment. The catch is unsecured debt is generally not discharged until debtors complete a three- to a five-year repayment schedule.

Debt Settlement vs. Bankruptcy: Potential for Debt Discharge

Winner: Chapter 7 Bankruptcy

Runner Up: Debt Settlement

Chapter 7 bankruptcies win hands down in this category. While a debt settlement can reduce your unsecured loans by 30 percent or more, a Chapter 7 bankruptcy can completely erase them, and it stops creditors from trying to make collections.
If you are only considering the potential for debt discharge, Chapter 7 bankruptcies are certainly the way to go. The problem is that qualifying for this type of bankruptcy is not easy. In 2005, Congress completely overhauled bankruptcy laws and made it much harder for debtors to file for liquidation bankruptcy.
Warning: Although Chapter 7 has the most potential for debt discharge, it is not a good option if you’re not ready to sell most of your property. For instance, do you have a family home or a new car you do not want to sell? Then a debt settlement or a Chapter 13 bankruptcy may be preferable.
Source: Industry estimates and average fees published by the United States Bankruptcy Court

Debt Settlement vs. Bankruptcy: Eligibility

Winner: Debt Settlement

Runner-up: Chapter 13

This was a close call. Although it is easier to qualify for a debt settlement than a Chapter 7 or 13 bankruptcy, debt settlements are useless for secured debt, such as a mortgage or a car loan. A Chapter 13 bankruptcy is the best option for debtors who have a regular wage, have some disposable income after paying their bills and don’t want to liquidate all their assets. However, to qualify, you must propose a detailed plan of how you will repay your debt within the next three to five years. It is hard to get a 7 approved because you must earn less than your state’s median income and have little to no disposable income to qualify.
The requirements for debt settlement vary from lender to lender. The general rule is you need to prove to creditors that you cannot afford to make your payments and that a settlement is in their best interest. This is easier said than done. Each lender has different rules and procedures to follow. Hiring a debt settlement company to negotiate on your behalf can dramatically increase your chances of success.
Here are a couple of things to consider when looking for a debt settlement company:

Do they have minimum and maximum limits on the amount of debt you can enroll?

Most companies require you to have a minimum amount of debt, which is usually around $10,000. Some lenders, such as Freedom Debt Relief, accept lower amounts. Other companies also have a maximum amount of debt you can enroll, such as $100,000. You will need to find a company with requirements that match your needs.

Debt Settlement vs. Bankruptcy: Damage to your credit score

Winner: Debt Settlement

Runner-up: Chapter 13

Debt settlement or bankruptcy will damage your credit score. However, a bankruptcy will stay on your credit report for 10 years from the date of discharge or the date you finish making your monthly payments.
To qualify for a debt settlement plan, you will need to stop making payments. Late payments stay on your credit report for up seven years from the date of the original delinquency. However, the effect on your credit score diminishes over time. Although both Chapter 13 and 7 bankruptcies stay on your credit report for 10 years, lenders are more likely to consider a consumer who chose to file a Chapter 13.

Debt Settlement Vs. Bankruptcy: Cost

Winner: Debt Settlement

Runner-up: Chapter 7

The cost of a debt settlement varies depending on how much you owe, how fast you can save for the settlement lump sum, and how much the debt is reduced.
A typical debt settlement fee is 20% of the debt balance, although some debt relief companies will charge 15% to 18% of the debt amount. However, these fees are levied once a debt account has been settled. Remember, the IRS considers forgiven debt as wages earned, so you may have to pay taxes on the money you save from the settlement. The good news is the IRS will often waive the tax on forgiven income if you can prove you were insolvent when the negotiation took place.
Filing for a Chapter 7 bankruptcy costs hundreds of dollars in application fees ($500 to $1,500) plus the bankruptcy lawyer’s fees. Expect fees ranging from $1,200 to $2,500. Filing for a reorganization (13) is even more expensive. To illustrate, the customary fee for preparing a Chapter 13 case in Northern Florida was $4,000 in 2015. Remember, these are upfront fees. No wonder some people are just too broke to file for bankruptcy.

Bankruptcy: Chapter 7 vs. Chapter 13

Now we have a better picture of the pros and cons of debt settlement vs. bankruptcy, let’s consider the two main types of bankruptcy in more detail.
In general terms, most of us know bankruptcy means throwing our hands up and waving the white flag to surrender financially. However, there’s more to it than that.

Chapter 7 bankruptcy relief

Chapter 7 bankruptcy is also known as a “liquidation” bankruptcy. When you file, a three to six-month process begins in which an appointed Chapter 7 trustee manages your case. They determine if you have any eligible assets they can sell to repay your creditors.
However, in many cases, debtors don’t have any eligible assets. The definition of qualified assets varies by state. For example, some have exemptions for your home or car up to a set amount.
Once the trustee sells your nonexempt assets and the filing goes through, they will discharge your debts.


To qualify, you need to prove that you can’t repay your debt. You can do so by showing that your current monthly earnings are less than or equal to the median income in your state for your family size.
If your earnings are too high, you can still qualify via the “means test.” It looks at your bigger final picture, including expenses and taxes. If you don’t qualify, Chapter 13 bankruptcy is an alternate option.

The Chapter 7 filing process

If you do qualify, the process involves the following steps:
1) File a petition with the bankruptcy court in your local area.
2) Provide the court with a schedule of liabilities and assets, current income and expenditures, executory contracts, and unexpired leases. Additionally, you need to provide a statement of financial affairs.
3) Give the trustee your tax returns for prior years and those undergoing filing during the case.
4) Submit proof of credit counseling and any debt management plan you create during the counseling.
5) Submit additional proof of earnings and financial accounts.
6) Pay a $245 filing, a $75 miscellaneous administrative fee, and a $15 trustee surcharge (can be waived in some instances).
Total cost=$335

What happens after filing bankruptcy under Chapter 7?

Once you file, “automatic stays” apply. This means that creditors can’t contact you to collect what you owe anymore—this applies to debt collectors for credit card companies and any other creditor included in the proceeding. Initiation or continuation of lawsuits, wage garnishments, and phone calls from creditors will stop. All of your property and debt become the court’s to handle.
You will also have to visit the courthouse for a creditor meeting 21 to 40 days after filing the petition. This is a meeting of the bankruptcy trustee and your creditors. During it, you will be sworn in and will answer questions about your financial affairs and property.
The trustee will determine if your case is an abuse of Chapter 7 or not and identify if you have any property that is not exempt from liquidation. The trustee’s goal is to repay as much as possible to creditors from your assets. A decision will be made and given to the court within ten days.
After the bankruptcy process is complete, all qualifying debt will be gone. The exceptions are child support, tax debts, student loans, secured debts you are paying, and debt that is not dischargeable due to reasons such as fraud or malicious acts.
Although the debts are gone, credit health is impacted. A low credit rating results in higher interest rates if you are eligible for any new credit. Bankruptcy can affect potential approval for even federal student loans. The court’s credit counseling companies can provide additional information on the impact of bankruptcy with a future creditor. Make the most of your required credit counseling; the class can help set up for future success.

Chapter 7 pros and cons

Here is a list of the benefits and the drawbacks to consider.
  • Shorter process than other bankruptcy types.
  • Discharge debts relatively quickly, restart building credit right away.
  • No requirements for repayment or debt management plan.
  • No limit on debt amount or solvency.
  • In many cases, a debtor’s assets are exempt from liquidation.
  • Grounds for denying an individual debtor a discharge are narrow.
  • Easier to explain to future lenders than a list of debt payments, repossessions, and defaults.
  • Low-cost.
  • Can lose the property you own.
  • Will lose credit cards.
  • Must undergo credit counseling.
  • Some types of debt cannot be forgiven (liens on property, taxes, etc.).
  • The case is subject to approval (cannot be considered an abuse of the law).
  • Must meet eligibility requirements.
  • Stays on credit history for ten years, three years longer than chapter 13.
  • Can’t file bankruptcy again for six years.
  • The case may undergo conversion into chapter 13

Chapter 13 debt relief

Instead of canceling debts and repaying them through the sale of your property, Chapter 13 reorganizes your debt for repayment. This option is also known as the “reorganization” bankruptcy or the “wage earner’s” plan. Repayment is structured over a three-, to five-year plan based on your state’s median income.


You have to make enough money to meet the payment obligations. Further, your secured and unsecured debt obligations have to be below the maximum set limits. The maximum limit for unsecured debt is $394,725, and $1,184,200 for secured debt.
The process for filing Chapter 13 bankruptcy is the same as filing for Chapter 7. However, you are required to set up a repayment plan.

What happens after you file for Chapter 13?

Once you file, efforts on the part of debtors to collect from you will stop.
While repaying your debts in full is not a requirement, you will need to use your disposable income to make payments toward it. Certain debts take precedence over others.
At the top of the totem pole are alimony, child support, tax obligations, and employee wages. Next are regular payments on secured debt and then unsecured debts you have fallen behind on.
When the plan ends, any remaining debts will be eligible for discharge as long as you are current on any child support or alimony payments and you have completed the credit counseling course through an approved credit counseling service.
One of the most prominent benefits is the stoppage of foreclosure, and you can pay your mortgage back over time. You can also reschedule other secured debts and extend them over the payment plan.
Total cost= $310 in filing fees plus repayments according to the plan you create. Bankruptcy attorney fees will vary based on location and the circumstances of your case.

Pros and cons of filing Chapter 13 bankruptcy

Here is a list of the benefits and the drawbacks to consider.
  • Save your house from going into foreclosure.
  • Keep all your nonexempt assets.
  • Discharge remaining debt after repayment finishes.
  • Bankruptcy comes off of your credit three years earlier than Chapter 7 bankruptcy case.
  • Have to make payments on debts according to the repayment schedule.
  • Longer bankruptcy process of three-five years.
  • Bankruptcy appears on your credit reports for seven years.
  • Must undergo credit counseling.
  • On public record.

Don’t be a victim

If you are comparing debt settlement vs. bankruptcy as a solution for your debt situation, watch out for debt relief options that seem too good to be true. Those looking for a debt relief option usually experience harassing creditors and threats of legal action. Do not make matters worse by falling prey to a scam in the debt settlement industry.
You can visit the federal trade commission website to obtain a free credit report, report fraud, and get information on consumer alerts.

Debt settlement vs. bankruptcy in Summary

Debt settlement programs and bankruptcies have their place in your debt relief toolbox. Which one is best depends on your financial situation and goals?
A debt settlement firm can reduce your debt by 30% or more, and there are no fees to pay until the debt is settled. Your monthly payments reduce immediately. Although debt settlement will significantly damage your credit score, late payments do not impact your credit rating as long as your credit report.
Both Chapter 7 and Chapter 13 provide bankruptcy protection. Both filings have long-term effects on your credit report (7 to 10 years). Chapter 7 bankruptcy is the best option for erasing the most debt. However, it is hard to qualify, and you will have to liquidate your assets.
Chapter 13 bankruptcy allows you to keep your property and repay your debts over three to five years but is expensive. It will cost $2,000 to $6,000 in filing and bankruptcy attorney fees, and most debtors never complete the repayment plan.

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Andrew Latham

Andrew is the Content Director for SuperMoney, a Certified Financial Planner®, and a Certified Personal Finance Counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.

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