Debt Settlement and Bankruptcy are two methods that you can use to clear some or all of your debts. Both come with their pros and cons. But if you are in serious need of financial relief, these are two options you should consider. Before we outline the pros and cons, let’s define each term.
What is Debt Settlement?
Debt Settlement is a way of clearing your debts by negotiating with a creditor to pay less than the amount you owe. You can handle this process yourself but working with a reputable debt resolution company is better. Depending on how much you owe, you can settle for 35 to 75 percent of the original amount. You can only clear unsecured loans such as credit card loans, personal debts, and medical bills in a debt settlement.
How Does Debt Settlement Work?
Creditors often accept a settlement when a debt is overdue. A debt relief company will suggest that you stop making payments on any remaining debts and instead put the money into a settlement account. Once there is a significant amount of money in the savings account, the debt resolution company will make an offer for a lump-sum payment of a lesser amount. If the creditor agrees, the company pays the sum and you are cleared of any further financial obligation.
The Pros and Cons of Debt Settlement
● Reduce Total Debt: Settlement companies are skilled at negotiating down on debts, and you will typically end up paying lower than the original amount you owe.
● Affordable Payment Plan: Debt relief companies work with what you can afford to create a payment plan. Also, by reducing the total amount, the debt becomes easier to pay.
● Quick Process: A good debt relief company can help you clear most of your debts in two to three years.
● Rebuild your credit: Settling your debts quickly will allow you to rebuild your credit.
● Avoid Bankruptcy: Experts advise that you should only turn to bankruptcy as a last resort. People often try to tackle their debts alone and become overwhelmed. Working with a reputable debt settlement company can allow you to pay back what you owe without facing major disruption to your life.
● Credit Damage: Debt settlement will impact your credit score. The period of paying into a settlement account rather than to creditors can affect your payment history, which damages your credit score.
● Additional Payments: Settling for a lower amount with creditors does not put you in the clear. The IRS will require you to pay part of your canceled or forgiven debt as taxable income. You will also pay the settlement company. Be aware that if a debt settlement company tries to ask for an upfront payment that this is a red flag since the FTC banned this type of action back in 2010.
● Ongoing Collection Efforts: Starting the process of debt settlement does not legally stop a creditor from trying to collect via wage garnishments or repossessions.
● Third-party Collection: Without a written proof by a creditor clearing you of debt, you may deal with a third-party agency that buys your debts from said creditors.
● Shady Debt Settlement Companies: There are many debt resolution companies with questionable practices (i.e., asking for upfront fees, as mentioned). Always check a company’s reputation before you decide to work with them.
What is Bankruptcy?
Bankruptcy is a legal process supervised by the federal bankruptcy courts that allow individuals and businesses to eliminate their debts partially or in full. Bankruptcy can be a long, complicated and tedious process that will require the help of an attorney.
How Does Bankruptcy Work?
Bankruptcy filing come in two options for individuals: Chapter 7 and Chapter 13 bankruptcy.
Chapter 7 is the classic bankruptcy that clears all your unsecured debts by liquidating your assets to pay back creditors. You should expect to lose a lot of property in Chapter 7. But some properties may be protected by federal or state laws and can be exempted. Chapter 7 only applies to unsecured loans, medical bills, and credit card bills. It still requires you to pay alimony, taxes, and student loans.
Chapter 13 bankruptcy reorganizes your payment plan to an agreed upon monthly amount for three to five years. This option allows you to keep some of your assets and discharges your debts after the stipulated time.
Bankruptcy Pros and Cons
● Automatic Stay: An automatic stay is an injunction under the US bankruptcy law that stops creditors from collecting debts. Under the automatic stay, creditors must stop any collection process and cannot harass or threaten you.
● Time: Bankruptcy filing under Chapter 13 gives you added time to pay off creditors, and you usually get to keep the property you are paying the debt on.
● Complete Debt Relief: Chapter 7 gives you a way to wipe out your debts and be absolved of all personal obligations.
● Credit Rebuilding: Clearing your debts can give you a chance to start a new process of building your credit up again.
● Credit Damage: A bankruptcy filing will stay on your credit report for 7-10 years. This can hurt your credit score and limits your ability to get any new credit.
● Future Employment: Employers cannot legally refuse to hire or promote you due to your declaring bankruptcy but keep in mind that most jobs consider bad credit in their employment criteria.
● Home Ownership: Similar to employment, you will have a hard time purchasing a house initially after filing for bankruptcy, especially Chapter 7. After a few years of improving your credit, you may qualify for an FHA (Federal Housing Administration) insured loan.
● Loss of Assets: This is perhaps the biggest issue with bankruptcy. Filing a Chapter 7 will mean giving up most of your assets including your home, car, and personal belongings.
● Non-Dischargeable Debt: Certain obligations like student loans, tax debts, and fines are non-dischargeable and cannot be removed with bankruptcy. In addition, the liens on your property cannot be discharged.
● Emotional Costs: Bankruptcy is a life-altering experience that can take a toll on one’s emotional and mental health. For many, the thought of losing their hard-earned personal belongings or business is a hard burden to bear.
● Failure: The strict monthly payments required in Chapter 13 can be a challenge to keep up. Only 37% of 2.6 million people have been successful in finishing Chapter 13 from 2007 to 2014. 51% were dismissed, and the remaining 12% were forced into a Chapter 7 bankruptcy. Many people default due to lack of resources, motivation, or some unforeseen challenges. Unfortunately, if you fail a Chapter 13 by skipping too many payments, your credit score sinks, and you will be required to pay back the debt in full plus interests. The automatic stay is also lifted, and creditors can begin collection processes on your assets.
Which Option is Best for You?
Choosing between bankruptcy or debt settlement can be a difficult decision. To guide you, we’ve prepared a few questions to consider.
1. HOW MUCH CAN YOU AFFORD?
The cost of a debt settlement will depend on how much you owe, the amount of debt that is forgiven, and how fast you can come up with a lump sum to pay back creditors. The debt resolution company will also take a percentage of the debt after it has been settled (15% to 20%). Finally, the IRS will consider the canceled debt as a taxable income, but you can get an exception if you show financial insolvency at the time of the settlement negotiation.
Chapter 7 bankruptcy will require a few thousands of dollars for application fees ($500 to $1,500) and paying an attorney. But losing properties is obviously a huge financial price. Chapter 13 bankruptcy will cost a lot, mostly due to inflexible monthly payments for at least three years. Every disposable income you have after taking care of necessities will go toward paying back creditors. You will also need to retain a bankruptcy lawyer for a long time.
2. HOW MUCH DAMAGE ARE YOU WILLING TO DO TO YOUR CREDIT SCORE?
Both bankruptcy and debt settlement will ruin your credit score. A Chapter 7 bankruptcy stays on your credit for ten years, while Chapter 13 stays on for seven years. Debt settlement may require late payments to creditors, which can also stay on your report for up to 7 years from the default date. However, lenders are more forgiving of late payments than bankruptcy. Generally, bankruptcy is worse for your credit score especially declaring under Chapter 7.
3. WHICH CATEGORY DO YOU QUALIFY FOR?
It is easier to qualify for a debt settlement than bankruptcy. In 2005, the Bankruptcy Abuse and Consumer Protection Act was passed and requires individuals to pass a means test to be eligible for Chapter 7 bankruptcy. The test will use Census Bureau Data on where you live, and your family size to determine if you earn less than the median income. To qualify, you must be below the average income for your state and family size or prove that you have no disposable income to make monthly payments on your debts.
To qualify for Chapter 13 bankruptcy, you must file your federal and state income tax returns for the previous four years. You must also have enough disposable income to make monthly payments to creditors. The court will require you to draft a repayment plan that outlines how you intend to pay off your debts for the next three to five years.
The requirements for a settlement will depend on the debt resolution company, but you must show true financial hardship and be able to make enough payments for a lump sum negotiation.
4. WHAT TYPE OF DEBT DO YOU WANT TO SETTLE?
Bankruptcy can clear most non-priority unsecured debts. A debt is unsecured if there was no promise to return the purchased item if you failed to pay.
Here is a list of the debts you can get rid of with bankruptcy:
● Credit card debts
● Medical bills
● Utility bills that are not from your current provider
● Cell phone bills that are not from your current provider
● Gym contracts
● Gas cards
● Apartment leases and mortgage balances (cannot be your present home or apartment)
● Unsecured personal loans
Debts you cannot clear with bankruptcy include:
● Student loans
● Child support
● Federal tax liens
● Car repossessions
A debt settlement can eliminate similar obligations as bankruptcy but can’t clear a wider range of debts.
Here are some debts you should not expect a debt settlement to clear:
● Current and second/third mortgages
● Current apartment lease
● Casino debts
● Attorney fees
● Car repair bills
● Student loans
● Alimony and child support
● Motorcycle credit cards
● Bank overdraft fees
● Rent-to-own accounts
● Criminal fines and penalties
● Current wage garnishments / judgments / litigation
Both bankruptcy and debt settlement comes with pros and cons. Chapter 7 bankruptcy may clear most of your debt but is hard to qualify for, you will lose property, and it stays on your credit report for ten years. Chapter 13 bankruptcy will allow you to keep your assets but take the longest time, have a notoriously low success rate and will stay on your credit report for seven years.
Debt settlement will impact your credit score, but are easier to qualify for, more affordable and take less time. At the end of the day, there are options to help you get out of debt, so you can begin to rebuild your financial life.
Schedule a free consultation today for a risk-free debt assessment. The only thing you have to lose is your debt.