Debt settlement Vs Bankruptcy, which would you prefer? You might as well ask “which arm would you like me to amputate?” Or “which of your children would like to send to a North Korean gulag?”
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. It’s like choosing which limb or child to lose. It may seem like an impossible decision, but being left-handed (or right-handed) or having a particularly messy child are factors to consider.
So which debt relief route is best: debt settlement or bankruptcy?
To answer that question we will determine the pros and cons of debt settlement and bankruptcy in four categories.
- Potential for debt discharge
- Damage to your credit score
- And 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?
Debt settlement is a debt relief program, typically offered by a debt resolution company, that negotiates the payment of a lump sum to creditors instead of the full amount you owe. It only works with unsecured loans, such as credit card, medical bills, and personal loans. To qualify for debt settlement, you must stop making payments on outstanding debts. 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.
What is bankruptcy?
Bankruptcy is a legal process by which individuals and businesses can eliminate or repay debts under the protection of the federal bankruptcy court. 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 certain cases, 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 always discharged. Instead, it is reorganized into affordable payments. If a debtor completes the repayment plan (three to five years of monthly payments), pending unsecured debt is discharged. However, the completion rates of Chapter 13 bankruptcies are extremely low. According to researchers, only a third of debtors complete the repayment plan. The catch is unsecured debt is generally not discharged until debtors complete a three to five years repayment plan.
|Chapter 7 Bankruptcies||Liquidation||7,234||7,241|
|Total Bankruptcies||All types||844,495||936,795|
|Source: Administrative Office of the U.S. Courts (AOUSC)|
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 a Chapter 7 bankruptcy is not easy. In 2005, Congress completely overhauled bankruptcy laws and made it much harder for debtors to file for a liquidation bankruptcy. The idea was to push debtors who could pay at least part of their debts toward a Chapter 13 bankruptcy.
Warning: Although a 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 new car you do not want to sell? Then a debt settlement or a Chapter 13 bankruptcy may be preferable.
|Debt Settlement||Chapter 7 Bankruptcy||Chapter 13 Bankruptcy|
|Unsecured Debt Reduction||50% to 60% (30% to 40% including fees)||Up to 100% (debtors must liquidate assets to repay creditors)||0% to 100% (Low success rates. Debtors must complete 3 to 5 years of monthly payments to discharge pending unsecured debt)|
|Eligibility||Inability to pay minimum payments (requirements vary by lender)||Strict income requirements (income must be lower than state median, little to no disposable income)||Debtors must prove they have sufficient income to repay secured debts over three to five years|
|Damage to credit score||Late payments stay on credit report for up 7 years||Late payments stay on credit report for up 10 years||Late payments stay on credit report for up 10 years|
|Cost||20% of debt||$500 to $3,500||$2,000 to $6,000|
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 a Chapter 13 bankruptcy, debt settlements are useless when it comes to 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 you bills, and don’t want to liquidate all their assets. However, to qualify, you must propose a detailed repayment plan of how you will repay your debts within the next three to five years. Chapter 7 bankruptcies are even harder to get. For instance, you must earn less than the median income in your state 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.
What is their customer service like?
We typically don’t care about the customer service of a company until we run into problems or have questions. It is important to find out ahead of time about the level and quality of support provided by a company. You can do so by researching the support channels they offer (phone, email, live chat, etc.) and by reading reviews from past customers. Look for companies like Debtmerica Relief and Rescue One Financial which are recommended by our community of users. Other debt settlement firms to consider are Pacific Debt and National Debt Relief.
Related: How to pay off credit card debts?
Debt Settlement Vs Bankruptcy: Damage to your credit score
Winner: Debt Settlement
Runner-up: Chapter 13
Both debt settlements and bankruptcies are going to damage your credit score. However, a bankruptcy will stay on your credit report for 10 years from the date of discharge (Chapter 7) or the date you finish making your Chapter 13 monthly payments.
To qualify for a debt settlement, you will need to stop making payments. Late payments stay on your credit report for up 7 years from the date of the original delinquency. However, the effect on your credit score diminishes over time. Although both Chapter 13 and Chapter 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 than one who went for a Chapter 7.
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 only charged once a debt account has been settled. Remember the IRS considers forgiven debt as income, 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 when 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 a Chapter 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.
Both debt settlements and bankruptcies have their place in your debt relief toolbox. Which one is best depends on your financial situation and your goals.
Debt settlements can reduce your debt by 30% or more and there are no fees to pay until the debt is settled. Unlike Chapter 7 and Chapter 11 bankruptcies, there are no upfront fees and your monthly payments will be reduced immediately. Although debt settlement will significantly damage your credit score, late payments stay less time on your credit report. Click here for a free consultation with a debt relief specialist. Find out what your debt relief options are. No strings attached.
A Chapter 7 bankruptcy is the best option for erasing the most debt but you it’s hard to qualify and will have to liquidate your assets. Expect serious damage to your credit score. A bankruptcy stays on your credit report for 10 years.
Chapter 13 bankruptcies allow you to keep your property and repay your debts over three to five years. However, they also stay on your credit for 10 years and don’t always discharge any of your debt. Chapter 13 bankruptcies are also expensive. It will cost $2,000 to $6,000 in filing and attorney fees, and most debtors never complete the repayment plan.
Andrew is the managing editor for SuperMoney 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.