Debt settlement vs. bankruptcy

Both are for people who have debt they can’t manage, but each comes with a different cost

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When you're feeling the stress of a mountain of debt, it's important to get your debt under control to preserve your health and well-being. If you're having trouble paying down your balances, debt settlement and bankruptcy are two options to consider. Each option has a few pros and some major cons, but one may be right for your situation.

Key insights

  • Debt settlement is a process in which you or a negotiator works with your creditors to devise a plan to pay less debt than you currently owe.
  • Bankruptcy is a legal process of eliminating debt through a court order. It may also involve repayment plans for some of your debts.
  • Negotiating debts on your own is a low-cost strategy for reducing debt that doesn’t involve hiring an attorney or advisor.

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.

Debt settlement companies can help you negotiate your debts, but watch for excessive fees or any suggestions of unethical tactics.

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. The Consumer Financial Protection Bureau cautions consumers about working with debt settlement companies because they can charge expensive fees and may lead to a creditor suing you.

Derek Jacques, a consumer bankruptcy attorney at The Mitten Law Firm in Southgate, Michigan, recommends that "debtors attempt to work with their creditors directly. As long as they are serious, this is a good option."

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.

» MORE: Is debt management a good idea?

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. A Chapter 7 bankruptcy is a liquidation of assets and is known as a "fresh start" because it wipes away most debts. Chapter 13 bankruptcy involves a repayment plan of three to five years based on your disposable income after allowed expenses.

Pros and cons of debt settlement

Before pursuing debt settlement, it helps to understand the pros and cons of this strategy, so you can make an informed decision.


The pros of debt settlement include:

  • It avoids the legal process of bankruptcy. 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.
  • The hit to your credit score isn’t as bad as the hit from bankruptcy. 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, note that debt settlement stays on your credit report for seven years; Chapter 7 bankruptcy stays on your credit report for up to 10 years.
  • You won’t pay legal fees. You don’t have to pay for an attorney or court costs when you pursue debt settlement.


There are some disadvantages to debt settlement:

  • Taxes may be owed on the amount saved. Creditors will issue a Form 1099-C for a forgiven debt of $600 or more, and you'll have to pay taxes on that forgiven debt amount as if it were income.
  • You’ll need to negotiate with each creditor individually. Unlike bankruptcy, where creditors are dealt with collectively, you'll have to negotiate with each creditor individually in debt settlement. This process can require significant time and effort from the debtor.
  • Creditors may not be willing to negotiate. When they receive an offer for debt settlement, creditors aren’t obligated to reduce balances or renegotiate repayment terms. On the other hand, bankruptcy applies significant pressure on creditors to negotiate, and the judge has the final say on repayment terms.

Pros and cons of bankruptcy

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


The pros of bankruptcy include:

  • Much of your debt is cleared. Except for unique situations, most forms of debt are wiped away or reduced through bankruptcy. Plus, your assets or income decides your maximum repayment amount, not the opinion of the creditor.
  • Discharged debts aren’t taxed. Debts wiped away in bankruptcy are forgiven completely without increasing your tax burden.
  • You can choose to repay some debts. Through a process called "reaffirmation," you can choose which debts you want to keep making payments on. This 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.


Consider the following cons of bankruptcy:

  • Your credit score will take a serious hit. A bankruptcy filing stays on your credit report for up to 10 years. This will affect your ability to obtain credit in the future, and it will make borrowing money more expensive.
  • You must pay attorney fees and court costs. 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.
  • You may not be able to discharge all debts. Some debts, like student loans, for example, either do not qualify for bankruptcy or are difficult to get discharged. You may be better off trying to negotiate with these creditors directly instead of filing for bankruptcy.

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, how much they make and other factors.

Selecting between debt settlement and bankruptcy often comes down to income versus the amount and type of debt owed.

When to choose debt settlement

Debt settlement is 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.

You may also try debt consolidation or a debt management plan if your debt settlement negotiation efforts fail. Debt consolidation replaces multiple debts with a single debt and one monthly payment. Often, this is a term loan in which you’ll be scheduled to pay off your balance entirely within a specified timeframe. Debt management plans are usually organized by nonprofit credit counseling agencies that receive your payments and distribute the money to your creditors according to renegotiated repayment terms. But while the agency may negotiate a lower interest rate, it won’t attempt to settle your debt for less than you owe.

» MORE: What is a debt management plan?

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.

Before deciding which path to pursue, it’s wise to discuss your financial situation with qualified professionals. Talk to legitimate nonprofit credit counselors and book an introductory meeting with a bankruptcy attorney to get their opinions. After doing your research and speaking with them, the answer should be much clearer.

Could your debt be reduced or forgiven? Take our financial relief quiz.


    Can you file for bankruptcy after a debt settlement?

    Yes, you can file for bankruptcy at any time. Debtors may not be able to keep up with monthly payments even after settling a portion of their debt. When debt overwhelms your finances, filing for bankruptcy may be the right choice.

    Does debt settlement improve your credit score?

    Settling a debt for less than the amount owed is a negative mark on your credit report that will likely lower your credit score. However, settling a debt does less damage to your credit score than letting it go delinquent, defaulting on it completely or filing bankruptcy.

    Can I take out a loan after a debt settlement?

    Yes, you’re eligible to take out a loan, get a credit card or apply for other credit products after a debt settlement. However, a lender may view you as a high-risk borrower if they see a debt settlement on your credit report, and they may give you a higher interest rate accordingly.

    How long does bankruptcy stay on your credit report?

    A Chapter 13 bankruptcy typically stays on your credit report for seven years after filing, while a Chapter 7 bankruptcy typically stays on your credit report for 10 years after filing. But the impacts that these filings have on your credit score and ability to get approved for new credit diminish over time.

    Bottom line

    If you're having trouble meeting your monthly payments, settling your debts 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 these maneuvers offer financial relief, they both have consequences that can last for years. Before pursuing either strategy, consult with a nonprofit credit counseling agency or bankruptcy attorney to get their professional advice.

    Article sources
    ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
    1. Capital One, " How Long Does Bankruptcy Stay on Your Credit Report? " Accessed Feb. 16, 2023.
    2. United States Courts, " Chapter 7 - Bankruptcy Basics ." Accessed Feb. 16, 2023.
    3. Experian, " Will Settling a Debt Affect My Credit Score? " Accessed Feb. 16, 2023.
    4. IRS, “ Chapter 7 Bankruptcy – Liquidation Under the Bankruptcy Code .” Accessed Feb. 22, 2023.
    5. IRS, “ Chapter 13 Bankruptcy – Voluntary Reorganization of Debt for Individuals .” Accessed Feb. 22, 2023.
    6. Consumer Financial Protection Bureau, " What are debt settlement/debt relief services and should I use them? " Accessed March 8, 2023.
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