Both filing for bankruptcy and pursuing debt settlement offer opportunities for significant debt relief. Each debt management approach has pros and cons that should be weighed carefully. Neither strategy is right for everyone.
Written by Attorney Todd Carney.
Updated July 28, 2023
It’s always tough to struggle with significant debt. Even when seeking some stability through debt relief, the “next steps” can be stressful. You likely don’t know the ins and outs of debt settlement or either major type of personal bankruptcy. While any debt management plan can help you get out of debt, each option has different financial, legal, and time requirements.
In this article, we’ll compare debt settlement and bankruptcy to help you make an informed decision about how you can best pursue the goal of becoming debt-free.
What Is Debt Settlement?
Debt settlement allows you to pay off a debt for less than what you owe. In a debt settlement program, you make an offer and negotiate with your creditor to lower your debt. Once you pay off the negotiated amount, usually as a lump sum, they report your debt as settled or paid. Creditors may be open to this because they get at least some of the money back. If they have to write off your debt or if you file bankruptcy and it’s discharged, they won’t get anything. Debt settlement isn’t the same as debt consolidation.
You can pursue debt settlement yourself or hire a company. If you do it yourself, you must have enough money on hand to make a major payment. If you go through a company, be wary of scams. The Better Business Bureau (BBB), Consumer Financial Protection Bureau (CFPB) and your state attorney general all provide information on reputable companies to work with.
Per Federal Trade Commission guidelines, debt settlement companies must disclose:
Any fees or conditions for the service
How long it will be until they provide each creditor with an offer
The potential consequences of not making your debt payments (if they instruct you to stop making payments)
That you have a right to remove the money set aside for debt without penalty
And other requirements.
If you work with a settlement company, you’ll give them money that they’ll use to make a settlement offer. This is usually paid overtime and held in an escrow account until the settlement payment is made. Not all creditors will be open to doing a debt settlement, and some won’t deal with third-party debt settlement companies.
Pros and Cons of Debt Settlement
Like most things in life, debt settlement has pros and cons. It’s beneficial because you ultimately pay less than what you owe. It will also free you up to focus your time and money elsewhere. This can help you stay current on your other bills.
Debt settlement also has its downsides. First, debt collectors will continue to hassle you until the debt they seek has been paid or settled. Also, you can’t even pursue debt settlement until you’re several months behind on your bills. During this time, you’ll have to deal with late fees, increased interest rates, and negative credit reporting. Plus, most people struggling to pay their debt aren’t able to come up with a big chunk of money, which is needed for debt settlement.
You may pursue a settlement but find a creditor doesn't want to work with you and instead chooses to sue you. If they do agree to a settlement, you might have to pay income taxes on the canceled or forgiven debt. And once the debt is settled, it can still hurt your credit score if the creditor reports it as settled rather than as paid in full. Finally, there are many debt settlement scams.
How Does Bankruptcy Work?
There are two types of bankruptcies, Chapter 7 and Chapter 13. In a Chapter 7 case, you provide information about your income, expenses, assets, and debts. If you’re employed, you’re also required to submit recent tax returns and pay stubs. Chapter 7 erases credit card debt, medical bills, car loans, personal loans, payday loans, judgments from credit card and debt collection agencies, and your utility bills. The debts that Chapter 7 bankruptcy can get rid of are called dischargeable debts.
Chapter 7 won’t get rid of child support, alimony, recent debts to the government, or most student loans. Also, if you have a loan that’s backed by property, known as secured debt, you may not be able to eliminate the debt unless you forfeit the property. Though there are some exemptions that may protect it. Once you file bankruptcy in a U.S. bankruptcy court, you’re likely to get the discharge 3-4 months later.
Chapter 13 bankruptcies serve people who make too much money to file for Chapter 7. Because they have a higher income, people filing a Chapter 13 case have to take part in a 3-5 year repayment plan to pay back part of their debt. These payment plans allow Chapter 13 filers to keep some of their property. After the 3-5 repayment plan is over, any remaining debts are discharged.
Is Chapter 7 or Chapter 13 Bankruptcy Better?
Chapter 7 bankruptcy is generally better because you can discharge many of your debts without repaying them. But it has limitations. If your income is too high, you might not qualify for Chapter 7 debt relief.
To qualify for Chapter 7 bankruptcy, you’ll have to pass a Means Test to see if you can afford to make monthly payments under Chapter 13 bankruptcy or not. In this test, you’ll look at your median income from the last six months compared to the median income in your state. Income includes alimony, child support, money from rentals, unemployment, and retirement money. If your income is greater than the median in your state, you may still qualify for Chapter 7 based on your expenses. Upsolve can walk you through these calculations.
Under Chapter 7 you may lose personal items like your home or car and other personal property if the items’ combined worth is too much. But this doesn’t happen often. Under Chapter 13, you can keep your personal property even if you’re behind on payments by incorporating it into the repayment plan. Also, if you want to purchase a home in the near future, you’ll have a longer waiting period following Chapter 7 bankruptcy than Chapter 13.
Since bankruptcy is reported in the public record and on your credit report, you may want to file Chapter 13 if you want to get it removed as soon as possible. Chapter 13 bankruptcy is usually removed from your credit report after seven years, while Chapter 7 stays on for ten years.
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Comparing Debt Settlements to Both Types of Bankruptcy
To decide whether debt settlement, Chapter 7 bankruptcy, or Chapter 13 bankruptcy is the best route for you, you’ll want to consider the time and cost of each, what ultimately happens to your debt, and what the effect will be on your credit report.
Bankruptcy Fees vs. Debt Settlement Costs
Bankruptcy will cost you time and money, but if you’re a low-income individual, you may qualify for an installment payment plan, fee waivers, or free legal help. The basic fees for Chapter 7 and Chapter 13 bankruptcy are the same. The difference is that you can only qualify to have these fees waived if you’re filing a Chapter 7 case and you make less than 150% of the federal poverty guideline.
The common bankruptcy fees are:
Pre-bankruptcy credit counseling course enrollment: $10-$50
Bankruptcy filing fee: $338
Pre-discharge debtor education course: $10-$50
Attorneys fees: Varies depending on the type of bankruptcy
Bankruptcy laws can be complicated and the process requires a lot of paperwork, so it can be helpful to get legal advice from an experienced bankruptcy attorney. Bankruptcy attorneys can be pricey, though. If you have a simple Chapter 7 case, you can use Upsolve’s free online filing tool to file without an attorney.
Debt Settlement Fees
On average, people pay about 58% of what they owe in a debt settlement. If you settle the debt yourself, you’ll save money, but it can take a lot of time. If you hire a debt settlement company, you’ll have to pay them a fee. This is usually around 15% of the original debt amount.
So say you are trying to settle $20,000 in debt. If you settle it yourself for the average debt settlement rate, you’ll pay just $11,600. If you hire a debt settlement company that charges you 15% of the $20,000 that you were in debt originally, you’ll $3,000 for the company’s service. If it settles for the average 58%, you’d pay the $11,600 plus the $3,000 fee or $14,600 overall.
Bankruptcy Is Public. Debt Settlement Is Private.
One major difference between bankruptcy and debt settlement is that bankruptcy is a public process and settlement is handled privately. Both Chapter 7 and Chapter 13 cases go through federal bankruptcy court. The cases are public record. The debt settlement process is private and happens between you and a creditor or debt collector. That is unless you hire a debt settlement company to negotiate on your behalf. Either way, the negotiation happens out of public view.
Bankruptcy Stops Debt Collection.
Chapter 7 and Chapter 13 bankruptcy have one major benefit over debt settlement and that is the automatic stay. Once you file your bankruptcy case, the automatic stay prevents creditors from going after you while you go through the bankruptcy process. A stay can prevent:
Creditors collecting on judgments from certain lawsuits
Utility companies from cutting off services
Foreclosures, but this will only be temporary, you need to ultimately catch up on your mortgage payments
Evictions, but again this is temporary
Wage garnishments and bank levies
Repossession, but the creditor can object during the bankruptcy process or go after it when the bankruptcy process ends
An automatic stay won’t prevent you from having to pay:
Court-ordered alimony or child support
Loans backed by your retirement account or pension
Debts you took on after you filed bankruptcy
Debt settlement doesn’t allow for an automatic stay, so you will continue to receive calls from creditors.
Debt Settlement vs. Bankruptcy – Your Credit Report
Filing bankruptcy has an immediate negative impact on your credit report, but may be better for your long-term credit health. Chapter 7 stays on your report for 10 years and Chapter 13 for seven years. Though your credit takes an initial hit, bankruptcy also gives you a fresh start with your debt and finances. So you can improve your score even during this 7-10 year period. With a significant amount of debt discharged, you should be able to make on-time payments for any new debt, which will improve your credit score.
How debt settlement impacts your credit score depends on how the creditor reports it to the credit bureaus. If it’s reported as “paid in full,” it won’t harm your credit score. If it’s reported as “partially paid” or “settled,” it will harm your credit score. The good news is that the negative impact on your credit report will decrease over time if you continue to pay your other bills on time.
Bankruptcy also provides you with a better credit score long term since several of your debts are completely forgiven and you are freed up to pay future debts. It’s likely to put you in a better position to receive loans in the future. That’s because lenders know you can’t file again for eight years. You can do debt settlements as often as lenders agree to them. So if you have a debt settlement on your credit report, lenders may hesitate to give you a loan.
Everyone’s Financial Situation Is Different
While it’s good to get acquainted with the basics of debt settlement and bankruptcy and how they differ, you’ll have to figure out what works for your financial situation. In some cases, debt consolidation or other forms of debt relief might serve you better. To figure out your next steps, consider attending a nonprofit credit counseling session. A free consultation with an accredited credit counselor can help you make sense of your debt, budget, and personal finances, so you can make the best decision for yourself.
Bankruptcy vs. debt settlement: Which is best? Each option has its pros and cons. Bankruptcy has several fees and requires a lot of paperwork. Because of this, you may want to hire an attorney to help, which can be expensive. The upside is that you may be able to get free legal help or have the fees waived. Either way, it is a public process and will remain on your public record and credit report for up to 10 years.
Debt settlements are private, but they can still hurt your credit if they are reported as settlements or partial payments. While you’ll end up paying less than your original debt amount, if you hire a company to help you settle your debt, you’ll often pay a hefty fee. Doing it yourself will take time and persistence, but it’ll cost you less. You’ll also need to have enough cash ready for a lump sum payment to pursue a debt settlement successfully.