What’s the Difference Between Debt Settlement and Bankruptcy

Debt settlement and bankruptcy are options for people who have more debt than they can afford to pay off, but they both come at a price. When you or a third party negotiates with creditors and lenders to pay less than you owe, this is referred to as debt settlement. Bankruptcy is a legal procedure in which you petition a bankruptcy court to have your debts discharged or restructured into a more manageable payment plan. To choose which choice is best for you, learn more about the differences.

What Is the Difference Between Debt Consolidation and Bankruptcy

Bankruptcy Debt Settlement
A deal between a borrower and a creditor to lower the amount owed on a debt.
When someone says they can't afford to pay their debts and requests a bankruptcy court to dismiss them, this is known as a Chapter 7 bankruptcy.
It's a little less bad for your credit than bankruptcy.
Credit scores and credit reports will suffer long-term damage.
The amount of debt that has been forgiven is considered taxable income.
You don't have to pay taxes on debt that has been discharged.

What Is the Difference Between Debt Settlement and Bankruptcy

Debt settlement is when a borrower and a creditor come to an agreement to minimize the amount of debt owing. Settlements are usually for unsecured debt, such as credit cards or personal loans, and the bargaining is usually handled by a third-party debt-settlement organization. When someone declares bankruptcy, they claim they are unable to meet their debt commitments and ask a bankruptcy court to erase their debts.

How They Work

In theory, paying less than you owe via debt settlement sounds terrific. To maximize your chances of settling, debt settlement companies normally recommend that you cease paying your bills for a few months before negotiating your sums. You save money for a lump-sum payment during this time, but late fees and interest accumulate, and your credit suffers. After some time has elapsed, the debt settlement firm will contact you to discuss a lower payment. The idea is that getting paid something is preferable to getting nothing, so some creditors will agree to settle. Debt settlement may not always be beneficial to you. Some creditors refuse to negotiate debt settlements, and if you stop paying, they may decide to sue you. Also, there are dodgy debt settlement companies out there, so be careful not to pick one that may make your financial condition worse. Avoid companies that charge an advance fee; it's against the law for debt settlement agencies to do so. If a creditor agrees to a settlement, the debt settlement company deducts the decreased total from the account into which you've been depositing funds. Only when the debt has been settled may the corporation levy a fee. While you can employ a debt settlement company to negotiate on your behalf, you can also call your creditors and try to work out a debt settlement deal on your own. Even better, if you contact creditors before you fall behind on payments, you may be eligible for a hardship program to help you better manage your finances. On the other hand, bankruptcy usually comes in two forms: Chapter 7 and Chapter 13. When people think of bankruptcy as a way to get rid of their debts, they usually think of Chapter 7. The problem is that this type is not available to everyone because it is based on your income. You must also usually liquidate the majority of your assets, albeit which ones you must sell depends on your state. As a result, Chapter 7 is sometimes known as "liquidation" bankruptcy. If your income is less than the state's median income, bankruptcy courts will enable you to file Chapter 7. If your income is higher, the court will conduct a "means test," which will examine your income and expenses over the previous five years. If you don't qualify for Chapter 7 because you earn too much money, you can consider Chapter 13, which entails creating a three-to five-year debt repayment plan. Yes, you'll still have to pay your bills, but your creditors won't be able to disturb you if you keep to the plan. The key advantage of a "reorganization" bankruptcy, sometimes known as a "wage earner's plan," is that your personal property is safeguarded. The Benefits and Drawbacks of Debt Settlement Pros

Reputable debt settlement firms may be able to reach reasonable agreements.
You have the option of avoiding the legal process of bankruptcy.
Debt settlement has a modest advantage over bankruptcy in terms of credit damage.

Cons

Settlement of debts isn't a simple fix.
It's possible that you'll have to be delinquent before you can settle.
Debt settlement firms impose fees for services that you could perform yourself.
The amount of debt that has been forgiven is considered taxable income.
You could face legal action if you don't make your payments on time.

The Benefits of Debt Settlement

Reputable debt settlement firms may be able to reach reasonable agreements. If you hire a good organization with industry connections, you might be able to secure a good settlement offer. You can avoid the legal procedure of bankruptcy by doing the following: Because a debt settlement is a private discussion (as opposed to bankruptcy, which is a public record), it will not come up in job interviews or other instances where your background is searched. Debt settlement has a modest advantage over bankruptcy in terms of credit damage. ThoughThought stopping paying your obligations for a few months will hurt your credit score, after your debt is handled, it will only stay on your credit report for seven years, rather than the ten years that Chapter 7 bankruptcy does.

The Drawbacks of Debt Settlement

Debt settlement is a long-term solution: Saving enough money to make lump-sum payments to creditors might take a long time, so this isn't always a quick option to get out of debt. It's possible that you'll have to be delinquent before you can settle: Instead of making payments, debt settlement businesses encourage you to save money that can be utilized for future payments. In the meantime, late payment costs will be applied to your accounts, your credit score will suffer as the length of your delinquency grows, and you may be subjected to harassing collection calls. Debt settlement firms charge fees for something you could do yourself: the debt settlement company will take a fee on top of the amount you'll still owe your creditors, reducing the amount you'll actually save. The amount of debt that has been forgiven is taxable income: Yes, you'll have to pay taxes on the money you saved by paying off your debt. You'll have to pay income taxes on $4,000 if you owe $10,000 and your creditor decreased the bill to $6,000. Your creditors may sue you for delinquent payments if you don't pay your bills before a settlement is reached, or if you cease paying as part of your debt settlement program. The Benefits and Drawbacks of Bankruptcy Pros

You can almost completely eliminate your debt.
Collection agencies will no longer pursue you.

You don't have to pay taxes on debt that has been discharged.

Cons

Attorney fees can be quite costly.
Credit scores and credit reports will suffer long-term damage.
Not all debts can be forgiven.
Bankruptcies are a matter of public record.

The Benefits of Bankruptcy

You can almost completely eliminate your debt: most unsecured obligations, such as credit cards and medical bills, are totally discharged under Chapter 7, providing you with a fresh start financially. Balances owed on secured debt, such as home and auto loans, can also be discharged. However, this requires the asset to be surrendered. Collection agencies will no longer pursue you: All collection calls will stop in both types of bankruptcy. You don't have to pay taxes on debt that has been discharged: Bankruptcy does not count debt cancellation or reduction as taxable income.

The Drawbacks of Bankruptcy

Attorney's fees can be costly: you'll have to pay for an attorney, which might cost thousands of dollars, in addition to a few hundred bucks to file your bankruptcy petition. negative impact on credit scores and reports over time. Bankruptcies can stay on your credit report for up to ten years, and the impact on your credit score will be instant. However, once your debt is discharged, your credit score can start to climb again—as long as your other payment habits stay favorable. When you file bankruptcy, you're still responsible for school loans, alimony, child support, and the majority of past taxes. Bankruptcies are recorded in the public record: The blemish on your financial reputation—and the fact that it can be discovered by anyone—is a significant disadvantage that could affect future employment opportunities or home rentals.

Which is the best option for you

Debt settlement and bankruptcy should not be your first options for debt relief. Debt settlement or bankruptcy may be a possibility if you've exhausted all other choices (such as credit counseling, debt management programs, debt consolidation, and so on). If you've managed to keep your accounts in good standing thus far, be aware that suspending payments to begin the debt settlement process may have a significant negative impact on your credit history, and you may be subjected to collection calls or even litigation. Filing for bankruptcy, on the other hand, relieves debt collectors' pressure, but it will become part of your public record and will appear on your credit report for up to ten years. However, bankruptcy is best for people who have a large amount of debt and no way of paying it off. Despite the fact that bankruptcy has credit repercussions and you'll have to pay lawyer fees, it stops debt collectors, and forgiven debt isn't taxed. Then, once your debts are erased (or, in the case of a Chapter 13 bankruptcy, you finish a payment plan), you can get back on track to recovery. Negotiating down what you owe through debt settlement could end up being the more attractive alternative for people with the resources to save some funds or who don't have enough debt to necessitate a bankruptcy filing. You may try to do it on your own, but there are no assurances that your creditors will cooperate. While engaging with a debt settlement firm is a risk, credible companies with good working connections with creditors should be willing to offer you an honest evaluation of how much it will cost, how long it will take, and how much money you could save up front.

Final Thoughts

While these approaches are considered "last resorts," for some consumers, they can provide respite and allow them to focus on repairing their finances. Learn what debt settlement and bankruptcy can do for you, how much they cost, and how they affect your short-and long-term credit health before you choose one. The optimal plan for you is determined by your specific financial condition. Consider talking to a credit counselor who can explain your alternatives to you. Then, if you decide to work with a debt settlement firm or a bankruptcy lawyer, be sure the firm or lawyer has a good reputation and takes the time to answer all of your questions. For those who are drowning in unsecured debt, debt settlement and bankruptcy are the two least desired options for financial recovery. However, if you're in over your head, one of these alternatives could be able to help you get your finances back on track.