If you are struggling with debt that you cannot pay, you have probably been told, or have read on the internet, that two of the ways to deal with the debt is through either debt settlement or bankruptcy. You have probably also read different opinions as to which one is better. The truth is that each of these options has its benefits and drawbacks, and whether or not it is right for you depends on your situation. In this article, I discuss the pros and cons of each of these options. I then talk about the effect of these options on your credit score. I also compare these two options to another alternative that you may have heard about—debt consolidation. And I conclude by giving you some ideas on how to determine which option to choose based on your specific situation.
So, let’s begin with debt settlement. Or you can click on one of the links below to go to another part of this article.
What is Debt Settlement?
Debt settlement is a voluntary process by which you and the creditor (the company to which you owe money) agree to a payoff of the debt for less than the full amount. Normally, the reason that a creditor would agree to accept less than the full amount is because payments on the debt are not being made, and the creditor would prefer to get something from you voluntarily, rather than having to sue you and then try to find assets which it can seize. So, the benefit to the creditor is that it gets paid without having to sue you, and it does not have to try to find assets that it can seize. Additionally, most creditors know that if a person owes significant debt and cannot settle it, the likely outcome is that the person will file for bankruptcy, and then the creditors will likely not get anything. The benefit of debt settlement to you is that you have to pay less than the full amount. Let’s look at the pros and cons of debt settlement.
Pro: Can choose which debts to settle and which to pay
When it comes to debt settlement, you can choose which debts you want to settle, which debts you want to pay in full, on which debts you want to continue making minimum payments, and which debts you do not want to deal with until a later time. So, for example, if you owe money on five credit cards, and one of the credit card companies is being very aggressive and demanding payment, you can choose to settle that one, while continuing to make minimum payments on the others. If you also owe money to a doctor, and you want to continue seeing that doctor, you can, at the same time, pay the doctor in full. And if an old landlord claims that you owe it money, and you disagree, you can do nothing with respect to that debt, and instead wait until either the statute of limitations expires, or the landlord takes action to collect the debt. Debt settlement gives you the flexibility to do all these things at the same, and you are not required to settle all debts just because you are settling one.
Pro: No formal court proceeding
Debt settlement is done by working directly with the creditor. Therefore, there are no formal court proceedings involved, and no need to comply with complex court rules or to obtain the approval of a judge. This means that you do not have to pay court filing fees, and incur other expenses normally associated with court proceedings. The only thing that is required is that you and the creditor agree on the terms of the settlement, and that each of you do what you agreed to do. Of course, this does not mean that the debt settlement process is completely informal, and you still have to make sure that the settlement is properly documented (see below).
Con: Need to have money to settle, generally lump sum payment
One of the largest negatives of debt settlement is that you need to have money to settle the debt. The whole purpose of a settlement is that you pay something to the creditor, and in exchange the creditor agrees not to collect the remainder of the amount owed. So, while you do not have to pay in full, you also cannot pay nothing. The amount that you will have to pay to settle any given debt can range widely (usually from 20% to 80% of the total debt). It will depend on a number of factors, including the type of debt, the amount of the debt, the type of creditor, how much collection activity the creditor undertook prior to settlement, and your financial resources. Usually, to get the best settlement offer, you will have to agree to pay the settlement amount in a lump sum, or over a short period of time (2-3 months). The longer the payment schedule that you request, the less likely it is that the creditor will agree to reduce the amount of the debt that you have to pay. Some creditors will agree to repayment terms of a year or longer, but they will almost always require payment of the debt in full.
In short, in order to settle, you need to have the money to pay the settlement. For example, if you have a credit card with a balance of $10,000, and agree to settle it for $4,000, you will have to have the $4,000 to pay the settlement. If you do not have such funds, then settlement may not be an option. Or, you may choose to “settle” by entering into a payment schedule that will not save you money, but will give you more time to pay.
Con: Must deal with each debt individually
Because settlement is an agreement between you and a particular creditor, if you owe money to more than one creditor, you have to deal with each creditor individually. This is not really an issue if you have only 2 or 3 creditors. But if you have multiple debts owed to numerous creditors, it may become very time-consuming to settle with all of them.
Con: Creditor has to agree
Settlement is a voluntary process between you and the creditor. That means that the creditor has to agree to settle the debt, and there is no way to force a creditor to agree if it does not want to. Although rare, in some cases a creditor will not agree to settle at all, and will demand payment in full. This is most common with debts that generally cannot be eliminated in bankruptcy, such as student loans. More commonly, a creditor may not agree to your settlement offer, and may insist on a higher amount. For example, you may offer to pay 30% of the debt, but the creditor may insist on 70%. Because a creditor is not required to agree to a settlement at all, a creditor is also not required to make a settlement offer that would be considered reasonable. If this happens, your choices are either to accept the settlement offer made by the creditor, or to look at other options for dealing with the debt, such as bankruptcy.
Con: Taxes on debt forgiveness
A very significant drawback of settlement is that the amount of debt that you do not have to pay, i.e. the “forgiven” debt, is considered income to you, and the Internal Revenue Service, and usually your state taxing agency, can tax you on that income. So, you could end up paying taxes on money that you do not actually have. This means that in calculating the true settlement amount, you need to add the amount you pay to the creditor and the amount you would have to pay in taxes.
There are some exceptions to this rule. The biggest exception is that there is usually no tax liability if you are considered insolvent at the time you entered into the settlement. In order to determine whether this exception, or another exception, may apply, you will want to consult with a tax professional before you agree to any settlement.
Con: Time frame
Depending on the number of separate debts you have, and how much money is required to settle all of them, the settlement process can take a long time. If you are like most people experiencing debt problems, you probably don’t have extra money sitting around to pay a settlement. So, in order to settle each individual debt, you will first need to save up the money for the settlement. Depending on your situation, that could take from a few weeks to a few months. Once you save enough money and settle one debt, you will need to repeat the process with each subsequent debt. If there are many debts, settling all of them could take several years. During that time, the debt amount is likely to increase due to accruing interest. In addition, so long as you have debts that are not being paid, you will likely not be able to rebuild your credit history. These factors make settlement a less useful option if you are dealing with many separate debts.
Con: You are responsible for making sure that the settlement is properly documented
When entering into a settlement agreement, it is not enough to have the creditor’s customer service representative tell you that if you pay a certain amount, the debt will be settled. In fact, a good rule of thumb is that anything you are told verbally means nothing, unless you get it in writing. I cannot count the number of times I’ve been told by a client that they were offered a settlement if they just paid a certain amount immediately, and after they made the payment, the creditor would change the terms, or would deny that there was a settlement agreement at all. So, again, any settlement agreement that you enter into must be in writing.
Unless you have a lawyer helping you, it is also your responsibility to make sure that the writing reflects the terms of the settlement as you understand them. For example, if you are making more than one payment, what happens if one of your payments is late? Can the creditor declare the settlement agreement null and void, but still keep the money you paid? It is not uncommon for creditors to include such a provision, but it may not be what you want or expect. As another example, is the creditor requiring you to sign a stipulated judgment in order to settle? If so, you need to understand the consequences of signing a stipulated judgment (for more on this see Should I Accept a Stipulated Judgment to Settle a Collection Lawsuit?). A settlement agreement that you do not understand may be worse than having no settlement at all, because it may give the creditor rights that it would not otherwise have, like the right to immediately go after your bank accounts if you miss a payment.
Con: Settlement becomes more difficult if you are already being sued
This last one is not so much a con, as it is a reality of the settlement process. It is easiest to settle a debt before the creditor has taken significant steps to collect. The reason is simple—the creditor has less time and money invested into getting paid, and is therefore generally able to accept a lower amount. Once the creditor hires a collection law firm, and especially once the collection law firm files a lawsuit, things become more complicated. Now, the collection law firm needs to be paid as well, and part of the settlement amount will go to the collection law firm. The creditor will want you to pay more simply because it will need to pay the collection law firm from the money it gets from you. In sum, settlement becomes more difficult once a lawsuit is filed. If you want to settle a debt, delay can be to your detriment.
Next, let’s look at bankruptcy.
What is Bankruptcy?
Bankruptcy is a formal legal process that allows you to eliminate many types of debt, including the most common types, such as credit cards, medical bills, payday loans, and most other unsecured debt. Bankruptcy exists to allow people struggling with debt to deal with it in one proceeding, and to get a fresh financial start. However, because bankruptcy offers very broad relief, and because it is a formal process, there are many rules that determine who qualifies for bankruptcy, whether or not a particular debt can be eliminated, and whether or not you have to give up anything in exchange for eliminating your debt. Let’s look at the pros and cons of bankruptcy.
Pro: Can deal with all debt at the same time
Bankruptcy allows you to deal with all of your debt at the same time. This means you don’t need to contact each creditor individually. In fact, in most cases, when you file for bankruptcy, you do not need to deal with your creditors at all. What happens with each of your debts is determined by the bankruptcy laws. For example, if you have ten different credit cards, and you file for Chapter 7 bankruptcy, all of the credit card debt will normally be discharged (eliminated). When compared to debt settlement, this can save you a lot of time and effort. If you were to use an attorney to settle several debts, filing for bankruptcy instead can also significantly reduce your legal expenses. In short, bankruptcy is particularly beneficial if you need to deal with multiple debts at the same time.
Pro: Creditors don’t need to agree
In order for you to file for bankruptcy, your creditors do not need to agree. Additionally, so long as you comply with the bankruptcy laws, your creditors do not get a say in whether or not you will receive a discharge of your debt.
Pro: Don’t need to pay creditors in chapter 7
In most Chapter 7 bankruptcy cases, you do not need to pay anything to your creditors. This means that any debt that can be discharged gets eliminated completely (For overview of what debt is not automatically discharged, read Debts Not Discharged in Chapter 7 Bankruptcy). Therefore, if you have no money to settle your debt, then bankruptcy may offer the solution that you need.
Pro: No taxation of discharged debt
Any debt eliminated through bankruptcy cannot be taxed. The bankruptcy laws specifically provide for this. So, in contrast with debt settlement, when you file for bankruptcy, you do not have to worry about paying taxes on the debt that you end up eliminating. This also means that you do not have to pay an accountant to try to figure out if you qualify for an exception, like you would with debt settlement.
Pro: Immediate debt relief
A major benefit of bankruptcy is that as soon as it is filed, collection activity against you must stop. This is a result of the bankruptcy automatic stay that goes into effect when a bankruptcy is filed. It applies to most wage garnishments (For more, see How to Stop a Wage Garnishment Right Now). This is a benefit that is not available outside of bankruptcy—in order to stop collection outside of bankruptcy, you generally either need the creditor’s consent, or must invalidate the underlying judgment that gave rise to the collection activity. If there is ongoing collection activity, such as a garnishment, or if collection activity is threatened, bankruptcy may be the simplest way to stop it (Read our Ultimate Guide to Stopping Garnishment in Arizona).
Pro: Elimination of lawsuits and judgments
If there is a already a lawsuit pending against you, your choices outside of bankruptcy are to either reach a settlement, or to defend the lawsuit. If neither is possible, or these options are not successful, then a judgment will be entered. A judgment generally will not go away unless it is paid in full. Bankruptcy provides an additional choice—it allows you to eliminate the judgment, or to stop and eliminate the lawsuit even before a judgment is entered. There are some exceptions to what types of judgments can be eliminated (for example, a fraud judgment may not be eliminated). In most cases, however, bankruptcy may be the most effective and efficient way to deal with an existing judgment.
Pro: Time frame
A chapter 7 bankruptcy generally only takes 4-5 months from filing to discharge. If you have multiple debts, this can be significantly less time that it would take to individually settle and pay each debt.
Con: Have to qualify
Because bankruptcy offers such broad relief, there are restrictions on who can qualify for bankruptcy. The specific qualifications depend on the type of bankruptcy. In order to qualify for Chapter 7 bankruptcy, you must meet one of two requirements: (1) your household income must be less than the median (average) household income for a household of the same size in your state, or (2) if you household income is higher, you need to have sufficiently high allowable expenses to meet the disposable income calculations established by the bankruptcy laws. These calculations can get fairly technical and complex. If you are not able to meet either of these requirements, in other words, if your income is too high, they you are not eligible for Chapter 7.
Chapter 13 bankruptcy does not have maximum income limits. However, in order to qualify for Chapter 13 bankruptcy, you need to have regular income from some source (employment, retirement, government assistance, etc.). In addition, your debt cannot exceed specific limits (approximately four hundred thousand in unsecured debt, and approximately one million in secured debt). If you do not meet these requirements, you are not eligible for Chapter 13. (Read Common Questions About Chapter 13 Bankruptcy).
Most people struggling with debt will qualify for either a Chapter 7 or Chapter 13 bankruptcy. However, the qualification requirements do create an additional hurdle that must be overcome in order to file for bankruptcy.
Con: Bankruptcy is complex
Bankruptcy is a complex process and is hard to do without a lawyer. A mistake during the bankruptcy process can have serious consequences. For example, it can result in you losing assets or property that you did not realize you would lose, it can result in the dismissal of the bankruptcy, or it can even result in the denial of your discharge (Read 7 Mistakes to Avoid When Filing for Bankruptcy in Arizona) . The process becomes more complex if your income is higher than the median (average), or if you are doing a Chapter 13 bankruptcy. In short, in order to successfully file for bankruptcy, you will almost always need legal assistance.
Con: May lose non-exempt property in chapter 7
In Chapter 7, you are limited in what property you are able to retain. If you have property that is not exempt, and you file for Chapter 7 bankruptcy, you may lose this property. The loss of this property may be worth it when compared to the amount of debt eliminated, or you may choose to do a Chapter 13 bankruptcy instead.
Con: Chapter 13 may not make sense if income is too high
If your income is very high, and you do not qualify for Chapter 7 bankruptcy, a Chapter 13 may not always be justified. The bankruptcy laws require that in a Chapter 13 bankruptcy, you make certain minimum payments to your creditors. The amount of these payments is determined by your disposable income, or your income minus your allowable expenses. If your disposable income is high relative to your overall debt, you may end up having to pay all of your creditors in full. In such cases, it may be less expensive to simply settle directly with the creditors.
Con: May not be able to file if had a recent prior bankruptcy
There are also limits on how often you can file for bankruptcy. If you had filed for bankruptcy within the prior eight years, your ability to file another bankruptcy and get a discharge may be limited, depending on the type of bankruptcy you filed previously and the type of bankruptcy you want to do now. Because of this, bankruptcy is not the best solution if you have a very small amount of overall debt, because once you file for bankruptcy and get a discharge of that debt, you are not able to file and get a discharge again for several years, even if you acquire new debt.
Con: Time frame
This applies to Chapter 13 bankruptcies. A chapter 13 bankruptcy takes 3 to 5 years. This means that you must remain under the supervision of the bankruptcy court for that duration, and must continue making the bankruptcy payments. If you fail to comply with the payment schedule, your case may be dismissed, or the bankruptcy plan may need to be modified. The time commitment required to complete a Chapter 13 bankruptcy must be taken into account before deciding to proceed with it.
Effect on Credit Score
You’ll notice that we have not yet talked about the effect of debt settlement vs bankruptcy on your credit score. The reason is simple: both debt settlement and bankruptcy will have some impact on your credit score. Because both will impact your credit score, it really becomes an irrelevant factor in deciding how to best deal with your debt—either way, your credit score will be impacted.
If you do an internet search for how debt settlement and bankruptcy affect your credit score, you may come across opinions that a debt settlement is better than bankruptcy, and will not drop your credit score as much. The truth is that no one really knows whether a debt settlement will affect your credit score less than bankruptcy, or vice versa, because the credit reporting agencies (Equifax, Experian, and TransUnion) keep the formulas used to calculate your credit score secret. The precise impact of either a bankruptcy or debt settlement on your credit score will depend on a multitude of factors. These include: the current condition of your credit, the reporting practices of your creditors, the size of the debts being settled or discharged, whether or not your settled or discharged debts are presently in good standing, how much less than the original balance the debt is settled for, and a multitude of other variables. While each of these factors will have an impact, how much of an impact it will have relative to the other factors is not know, and can only be guessed.
The one thing that is fairly certain is that if you have a high credit score before you do debt settlement or bankruptcy, then it will drop more than it would if your starting score was low. So, the lower your credit score to begin with, the less of an impact bankruptcy or debt settlement will have on it. But, ultimately, both debt settlement and bankruptcy will have an impact on your credit score.
What about Debt Consolidation?
If you have looked into debt resolution options, you have probably heard about debt consolidation as an alternative to both debt settlement and bankruptcy. The truth is that debt consolidation is not a separate debt resolution option, but is just debt settlement or debt refinancing under a different name. The term “debt consolidation” is just a term used by companies offering these services to get you to sign up with them. Although there are some companies that offer debt consolidation services for free, many are profit-oriented, and they make money when you sign up with them.
There are two types of debt consolidation: (1) debt refinance—or true debt consolidation, and (2) debt settlement.
Debt refinance involves consolidating all of your existing debt into a single debt. This is the true consolidation, because it involves you actually combining all of your debt into one loan. In practice, this means that you take out a new loan sufficient to pay off all of your debt, and use the funds from the loan to pay off your existing debt. You then make payments on the new loan. What’s important to note about this type of debt consolidation is that you don’t actually save any money. You simply combine multiple debts into one, but the overall amount of the debt remains unchanged. However, if the interest rate on the new loan is lower than the interest rate on the debt you paid off, you may save money on the interest that you have to pay.
In order to do this type of debt consolidation, there has to be a lender willing to give you the new loan. Since most people considering debt consolidation probably already have bad credit, it is unlikely that any lender will be willing to issue them a new loan. The only exception to this is if you have property that can serve as collateral for the loan, such as a house, in which case a lender may be willing to issue a secured loan. However, taking out a secured loan to deal with unsecured debt is generally a very bad idea. For more on why this is so, read The Basics of Financial Planning and Dealing with Debt. As a practical matter, then, debt refinance will not be an option for most people looking at debt consolidation.
The second type of debt consolidation is debt settlement. This is the type of debt consolidation you most often see advertised. This type of debt consolidation usually works as follows: A company will advertise debt consolidation with a single monthly payment. You sign up with the company, give it a list of your debts, and start making the payments. Part of your payments will go to pay the company, the rest will be accumulated by the company in a trust account. Once the company has accumulated what it thinks is enough money to settle one of your debts, it will contact the creditor and try to settle the debt. If it is successful, it will pay the creditor, and then will wait until you have made enough payments so that it can try to settle the next debt. If it is unsuccessful settling with one creditor, it may try to settle with another one, or may tell you that it cannot help you.
As should be obvious, this process is the same as the debt settlement process discussed earlier in this article. The only difference is that you are paying someone else to do it for you. If you are dealing with a reputable company, it will make clear that what it is really doing for you is debt settlement, and that there is no guarantee that its debt settlement efforts will work. However, if the company is not reputable, it will likely try to conceal the true nature of its services, or put the information into the fine print in the contract that it has you sign.
In sum, debt consolidation is either just debt settlement by a different name, or it involves refinancing the debt and paying it in full, and is not a good option if you already have difficulty paying your debt.
Debt Settlement vs Bankruptcy: what is the best choice?
Whether bankruptcy or debt settlement is right for you will of course depend on your specific circumstances, but there are some basic rules of thumb you can follow. If you have a small amount of debt, under $5,000, settlement is usually the way to go. The primary reason is that bankruptcy is unlikely to save you a significant enough amount when compared to a settlement. Additionally, you preserve your ability to file for bankruptcy if you acquire more debt later. If your income is very high (i.e. significantly higher than the median for a household of the same size), and your expenses are relatively low (less than half of your take-home pay), settlement may be the better choice, because it will generally allow you to save more money.
On the other hand, if you have many different debts (more than five), bankruptcy is likely the better option, because it will allow you to deal with all the debt at the same time. Even if you have few debts, but at least one of them is very large (e.g. over $10,000), bankruptcy is likely a better option, especially if you have limited funds to dedicate to settle your debt.
If the different factors conflict, for example if you have very high income but also very high debt, then all factors need to be weighed to determine the best option. In such situations, and in any situation where the best course of action is not obvious, it is a good idea to obtain proper legal advice from an attorney who specializes in debt matters.