Debt Settlement vs. Bankruptcy

What is debt settlement?

Debt settlement is the process of negotiating amounts owed or payment terms with each creditor individually. Creditors are not obligated to restructure your loan or lower your balance owed. However, they’re often willing to negotiate with a debtor to avoid potentially getting less money if the debtor files for bankruptcy.

"Debtors [can] attempt to work with their creditors directly,” said Derek Jacques, a consumer bankruptcy attorney at The Mitten Law Firm. “As long as they are serious, this is a good option."

Debt settlement companies can help you negotiate debt, but watch for high fees or unethical tactics.

When negotiating your debts, creditors may lower your balance, reduce your interest rate or extend repayment terms to make it easier for you to pay. If the creditor lowers your balance, the forgiven amount may be considered taxable income. Factor in the potential for taxes when deciding if you'll accept their revised payment terms.

Consumers who don't want to handle these negotiations themselves can hire a debt settlement company to negotiate on their behalf. These companies often charge their clients 15% to 25% of their enrolled debt. However, the Consumer Financial Protection Bureau (CFPB) cautions against working with debt settlement companies because they can charge expensive fees and may lead to a creditor suing you.

Pros and cons of debt settlement

Before pursuing debt settlement, it helps to understand the pros and cons of this option compared to bankruptcy. 

What is bankruptcy?

Bankruptcy is a legal process that stops collection efforts and provides debtors the opportunity to reorganize their finances. Consumers and businesses use bankruptcy to avoid foreclosure, stop wage garnishments, renegotiate contracts and financially reboot.

There are multiple types of bankruptcy, which vary depending on how much you owe and your ability to repay your creditors. Two common types are:

• Chapter 7: A Chapter 7 bankruptcy is a liquidation of assets. It’s known as a fresh start because it wipes away most debts.
• Chapter 13: With a Chapter 13 bankruptcy, you’ll set up a repayment plan of three to five years based on your disposable income after allowed expenses.

» MORE: Does bankruptcy clear all debt?

Pros and cons of bankruptcy

Bankruptcy is typically used as a last resort when your debt or monthly payments overwhelm your finances. Consider the pros and cons to understand the impact bankruptcy will have on your credit and lifestyle.

Comparison: debt settlement vs. bankruptcy

The table below compares debt settlement and bankruptcy.

Process and fees

Debt settlement doesn't have a legally defined process. Therefore, you can negotiate your debts independently as you see fit without involving attorneys or the court system. Or you can work with a debt settlement company for a fee.

However, the average Chapter 7 bankruptcy attorney charges $1,200 to $2,500, and court filing fees typically exceed $300. These additional costs may not make filing bankruptcy worth it for some people.

Credit impact

With debt settlement, creditors typically report to the credit bureaus that you settled your debt for less than the amount owed. However, you can try to negotiate with creditors to avoid any negative marks on your credit. If that doesn’t work, debt settlement stays on your credit report for seven years.

In comparison, a bankruptcy filing stays on your credit report for up to 10 years. This will affect your ability to get credit in the future, and it will make borrowing money more expensive.

Negotiating with creditors

With debt settlement, you'll have to negotiate with each creditor individually. Creditors also aren’t obligated to reduce balances or renegotiate repayment terms. With bankruptcy, you’ll deal with creditors collectively. Bankruptcy applies significant pressure on creditors to negotiate, and a judge has the final say on repayment terms.

Debt reduction

With bankruptcy, most forms of debt are wiped away or reduced. Plus, your assets or income decides your maximum repayment amount, not the opinion of the creditor. You can also choose if you want to keep making payments on certain debts through reaffirmation, which may be a wise choice if the debt has a co-signer or if you’d like to mitigate some of the damage a bankruptcy will do to your credit score.

With debt settlement, you’ll need to settle debts separately, and you might not be able to settle some of your debts if creditors aren’t willing to negotiate.

Should you choose debt settlement or bankruptcy?

Choosing between debt settlement or bankruptcy can be a challenge for some debtors. While both paths have distinct pros and cons, many situations are too complex for a simple answer. But for some debtors, the answer is based on how much they owe, their income and other factors.

Choosing between debt settlement and bankruptcy often comes down to how much debt you owe.

Before deciding which path to pursue, it’s wise to discuss your financial situation with qualified professionals. Talk to a nonprofit credit counselor or schedule a consultation with a bankruptcy attorney to get their opinions.

When to choose debt settlement

Debt settlement can be a good choice if you have a stable income and the money to make monthly payments. Many consumers and small businesses can afford monthly payments after negotiating a lower interest rate, an extended repayment period or a reduced balance. If you have access to cash, you may be able to negotiate a substantial discount by making a one-time payment.

When to choose bankruptcy

Bankruptcy halts all collection activity, wage garnishment and foreclosure proceedings. It’s a more extreme action, but it’s necessary in some situations to preserve your assets. Additionally, it may be your only option if creditors are unwilling to negotiate reasonable repayment terms that you can afford.

» MORE: How long does it take to recover from bankruptcy?

FAQ

Bottom line

If you're having trouble making payments, settling your debt or filing for bankruptcy may be right for you. Debt settlement involves negotiating to reduce the amount of debt you owe, and it can be done at any time with one or more of your creditors. Bankruptcy is a legal process in which some of your debts may be discharged, though you may also be required to liquidate certain assets to pay creditors or reorganize your debts into a new repayment plan.

While both debt settlement and bankruptcy offer financial relief, they have consequences that can last for years. Before pursuing either strategy, consult with a credit counseling agency or bankruptcy attorney to get their professional advice.