Debt Settlement or Bankruptcy: Which Is Right For You?

Is there a faster way out of debt? Yes, there is, and it’s between debt settlement and bankruptcy. These are both efficient, but each has different implications for your future financial status.

It’s high time you started considering these two options if you have bogus unpaid debts. This article will delve into the two to help you decide.

Choosing Between Debt Settlement or Bankruptcy

Before deciding between the two, it’s important to get more information. This will help you decide better. Understanding the benefits and downsides will enable you to apply what you think is best for your finances.

What Is Debt Settlement?

Debt settlement happens when the lenders agree to accept less than the full debt in order to finally resolve the debt. By doing so, the financial burdens of the debtors are alleviated. This can be used if you have unsecured debt like credit cards.

To settle your debts, you can either hire a debt settlement firm to negotiate on your behalf or negotiate yourself. Hiring a debt settlement firm saves time. It also protects you from the hassle of dealing with and getting yourself out of possible lawsuits.

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Pros

Debt settlement offers several advantages, particularly for those with many debts they don’t have the means to pay. By settling the debt, the debtor can make lower payments and prevent long-term damage like a possible lawsuit or more debt charges. Most importantly, it prevents waste of time and effort and can save you a lot of money. This can help the debtor get their feet back up and regain financial stability.

Cons

Despite its advantages, debt settlement also presents several drawbacks. From the start, lenders might be reluctant to negotiate with the debtors. Additionally, not all creditors are willing to negotiate, and there’s no guarantee of a successful settlement. Once they approve the payment, this can affect the debtors’ credit score, and they must pay tax on it.

What Is Bankruptcy?

Bankruptcy is a legal process that lets individuals or businesses go through when they can no longer pay the money they owe. A court ruling decides whether the debtors have to pay all their debt, partially or not, depending on their capacity to repay.

Chapter 7 and Chapter 13 are the two legal options available. Chapter 7, “liquidation bankruptcy,” means using the debtor’s assets to pay off their debt. The lenders do not run after the rest of the debt.

On the other hand, Chapter 13, known as “reorganization bankruptcy,” lets the debtors keep their primary assets like their home and car, but they must pay off their debt within a period. A partial repayment also needs to be paid first.

Pros

There are many benefits of Chapter 7 bankruptcy. First, it offers a fresh start by eliminating many unsecured debts. The process is typically quick, taking three to six months on average. Additionally, it stops lenders from going after you. Lastly, unlike other forms of bankruptcy, there’s no need to establish a repayment plan.

Simultaneously, Chapter 13 has a few advantages, like it won’t seize any of the debtor’s properties and offers a good way out through a repayment plan. Moreover, Chapter 13 allows debtors to reschedule secured debts and extend them over the program’s life, which can lower payments. Importantly, co-signers and other third parties are not affected by the debt.

Cons

The biggest drawback of Chapter 7 bankruptcy is the debtor can lose essential properties like their home and cars just to pay off debt. Meanwhile, Chapter 13 bankruptcy also poses some disadvantages. Since it needs to be repaid within 3-5 months, it can put a toll on the debtor.  Unfortunately, the process is more expensive since it needs higher attorney fees than the other type of bankruptcy.

These bankruptcies are public records, so anyone doing a background check on the debtor can see this. Another drawback is that the debtor’s credit score can become low, making it hard to qualify for future homes, loans, etc.

Read More: How Do I Avoid Bankruptcy?

Applying Debt Settlement and Bankruptcy in Real Life: An Example

Fred hasn’t made his minimum payments for three months — he’s been struggling with his finances for over a year, and his bills, like utilities and medical bills, got bigger despite his low income. Then, Fred came to a bitter conclusion that he’d have to file for bankruptcy if things got worse.

After calculating the amount needed to keep paying his mortgage, he realized that he could sustain his mortgage if he dropped his credit card bills.

Fred went for credit counseling and was advised to opt in for the debt settlement process. He halted his monthly payments and notified his credit card agency that he couldn’t meet up with the payment schedule.

With the help of a debt settlement company, he negotiated with his lenders and consolidated all his debts into a single payment.

Also, Fred’s debt and interest rate were reduced considerably without risking being reported to the credit rating authorities.

Fred paid his monthly payments in full to the debt settlement company, as agreed, and cleared all his loan debts in a year, thereby preventing his creditworthiness from being damaged.

Another Example

Janet’s case was different from Fred’s — both were in debt, but Janet had more challenges.

Her husband was laid off and couldn’t find another job. She could barely pay the mortgage, let alone make a monthly payment from her account. When she thought things couldn’t get any worse, her husband had a heart attack, and the medical fees were unbearable.

After studying all available options, Janet and her husband filed for Chapter 7 bankruptcy.

Their homes were defended from foreclosure as long as she made payments and all her debts were eliminated, giving her many debt relief options.

In Janet’s case, debt settlement isn’t advisable, as she and her husband didn’t earn enough income to settle. Bankruptcy was inevitable.

Read More: Types of Credit Cards: Which Should You Get?

Factors Deciding Between Debt Settlement and Bankruptcy

Deciding between debt settlement and bankruptcy depends on several key factors:

Type of Debts

Choosing between the two depends on what type of debt you have. If you have student loans, alimony, and child support, note that it can’t be discharged in bankruptcy but can sometimes be negotiated in a debt settlement. Moreover, if you have unsecured debts such as credit card debt and medical bills, you are often prime candidates for debt settlement and bankruptcy discharge. In contrast, if you have secured debts like a mortgage or car loan may not be as easily negotiated or discharged.

Amount of Debt

If your debts are too large to repay realistically, bankruptcy may provide a fresh start. However, debt settlement might be a viable option if you only have a few accounts in trouble and you have enough income.

Assets

If you own significant assets you want to protect from liquidation, debt settlement may be more beneficial than Chapter 7 bankruptcy. This is because, in a Chapter 7 bankruptcy, non-exempt assets can be sold off to repay your creditors, potentially resulting in the loss of property or other valuable items. On the other hand, debt settlement is designed to negotiate down your debt amount without involving liquidating assets.

Future Financial Goals

If you plan to buy a house or car in the next few years, you may want to avoid bankruptcy due to its long-term impact on your credit score. A default on your credit report can make securing loans or credit much more difficult. This is because it signals to lenders that you’re a high-risk borrower. This affects your chances of approval and can lead to higher interest rates.

Legal Protection

Bankruptcy offers an automatic stay preventing creditors from collecting while the bankruptcy case is ongoing, which is not true in debt settlement. This automatic stay can provide immediate relief from harassing phone calls, letters, or even potential lawsuits from creditors. Furthermore, in cases of secured debt, the automatic stay can temporarily halt foreclosure or repossession processes, providing the debtor some breathing space to assess their financial situation.

Cost

Debt settlement can be less expensive than bankruptcy when considering court costs and attorney fees. However, debt settlement companies also charge fees. Typically, it is a percentage of the debt being negotiated. If a significant portion of your debt is forgiven through settlement, it could be considered taxable income.

Impact of Bankruptcy and Debt Settlement on Credit Score

Have it at the back of your mind that bankruptcy and debt settlement could negatively affect your credit score and lessen your credit or FICO score for years. Regardless of which chapter you file under, bankruptcy would reduce your creditworthiness. The higher the score you start with, the lower it drops. A Chapter 7 bankruptcy is boldly written on your credit report for a decade from the day of filing, while a Chapter 13 bankruptcy remains on your credit report for seven years.

Bankruptcy Laws and Regulations

There are bankruptcy laws and regulations that determine what happens to your funds after the final judgment is declared. As mentioned earlier, Chapter 13 requires partial repayment, while Chapter 7 takes care of your debt. The bankruptcy judge determines how much you must repay according to state laws, which may involve debt collectors.

Debt settlement allows you to make lesser payments to free your account from outstanding debts and increase your savings account soon. Assuming you’re unable to make payments immediately (most debtors can’t ), you’d be required to take a break until you’ve saved enough to cover the debt.

SUMMARY

Settling credit card debt is sometimes tasking. If you need to learn how to negotiate debt with credit card companies, hire a debt settlement agency or bankruptcy attorney, and consult some financial or credit counselors.

For those who want to know the good option between debt consolidation and bankruptcy, anticipate our next post titled: debt consolidation vs bankruptcy.

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Frequently Asked Questions

Why Would Lenders Want to Negotiate Your Debts for Less Than You Owe?

Creditors don’t want you to file for bankruptcy because there’s a possibility of total debt elimination in court. They prefer getting less than you owe via debt settlement to avoid going to court.

Can All Debts Be Settled Through Debt Settlement?

No, not all debts are eligible for settlement. Debt settlement is generally used for unsecured debts, like credit card debts or personal loans. Secured debts, such as mortgages or car loans, and certain unsecured debts, like student loans or child support, are typically not eligible for debt settlement.

Does Bankruptcy Erase All Debts?

No, not all debts are erased in bankruptcy. Certain types of debt, like student loans, child support, alimony, and some tax debts, generally cannot be discharged in bankruptcy. It’s essential to consult with a bankruptcy attorney or financial advisor to understand which debts can be removed.