Settlement vs Bankruptcy
Bankruptcy and Debt Settlement are both viable solutions to getting rid of debt, but they do carry some major differences in how they are paid off and the effects that they have on your credit score. Compared to a debt management plan, both debt settlement and bankruptcy can be more damaging to your credit profile, but depending on your income level and ability to repay the amount owed, they can be better options for debt relief in the short term.
Debt settlement is a negotiation process where you or a company acts on your behalf to work out an agreement to repay a portion of the debt owed to creditors.
Debt Settlement Pros
When done successfully, the settlement allows a debtor to significantly lessen the amount of debt carried while avoiding the major damage to their credit profile & stigma that is paired with filing for bankruptcy. Settlement can sometimes reduce the amount of debt to 20% of what it was.
Compared to bankruptcy, debt settlement can take far less time to complete & creditors receive more of what they are owed. The benefit to creditors is much greater when they settle than when the debtor files for bankruptcy, so their obligation to settle is higher if they believe a debtor cannot repay the entire debt.
Debt Settlement Cons
Debt Settlement can seem like an enticing option that would work for anyone in debt, but it does have a few major drawbacks that should be considered first:
- Debt Settlement is a form of debt relief that must be completed for each creditor that is owed money. For example, if you have 5 credit cards, then each one has to be settled individually with the specific credit card company where the money is owed.
- Creditors may not agree to the settlement amount. Not all creditors are willing to negotiate with debt settlement companies & may not be willing to lessen the owed amount if they believe a debtor can pay the debt.
- Even if they are willing to negotiate, the amount of debt that is forgiven through settlement is considered as taxable income by the IRS. The amount of debt reduced by the settlement is piled onto your taxable income & taxes must be paid to the state and federal government. If a $5,000 settlement is reached for a $10,000 debt, then this leaves the debtor with an additional $5,000 in taxable income as a result of the debt amount forgiven.
- There may be additional fees or interest to be paid to the debt settlement company. When a debt is settled, you agree to make payments to the debt settlement company who then pays the creditor the agreed upon amount on your behalf.
If A debtor fails to make payments to the debt settlement company after a settlement has been reached, then they may be subject to steep additional fees or interest as a result of nonpayment. This could result in having to pay a debt that is even larger than the original debt that was being negotiated to reduce. Creditors can also take legal actions to garnish wages for debtors who cannot pay a settlement.
- Debt Settlement can have a negative impact on your credit score. While the goal of a settlement is to negotiate a better deal on the debt owed, this process can take time and showing creditors that you are not willing to pay the debt can be a risky move. It may be necessary to save for a lump sum to pay off a settlement cost, but before the debt has been repaid by the amount agreed upon in the settlement, creditors are still expecting to receive payment & the debtor’s credit score can be negatively impacted as a result.
Bankruptcy is a legal process where your lawyer files a petition to a court stating that you are unable to pay off your debts. Filing for bankruptcy is a legal process that can guarantee that at least some or all of your debt will be wiped out, whereas debt settlement is a form of arbitration that comes with no guarantees of reducing the overall level of debt.
Both personal forms of bankruptcy, Chapter 7 and Chapter 13, offer significant ability to relieve debt, but are also paired with long-lasting damage to your credit score & are unable to erase all forms of debt. Debts from income taxes, student loans, and payments to child support cannot be wiped out through bankruptcy.
Chapter 7 Bankruptcy
A Chapter 7 bankruptcy can erase most debts but may require a debtor to liquidate most or all of their assets depending on which state they live in. It is important to understand which assets are protected by the state before filing for Chapter 7.
This type of bankruptcy does not require any repayment & does not require the filer to pay taxes on the debt that was forgiven. It can also be completed in months where Chapter 13 can take years.
Chapter 7 bankruptcy has a few distinct disadvantages compared to other debt relief options:
- Causes significant damage to credit score for 10 years.
- Cannot be filed again for another 8 years.
- Can leave debtors vulnerable to losing critical assets such as a car or house in some states of the U.S.
- Only available to families that fall below a certain income level.
Chapter 13 Bankruptcy
A Chapter 13 Bankruptcy allows a debtor to repay most or all of their debt while being able to keep their assets. This type of bankruptcy also allows you to avoid paying taxes on the debt forgiven & can be filed again just two years later.
Chapter 13 bankruptcy does have its disadvantages:
- Debtors who are unable to make payments toward repaying the debt are likely to have their bankruptcy case dismissed, leaving them open to actions from debt collection agencies with no way of getting back any of the capital already put into repayment.
- Causes significant damage to credit score for 7 years.
- Obligation to repay debt may last 3-5 years, where Chapter 7 may offer more immediate debt relief.