When you’ve reached the end of your rope, goes the maxim, tie a knot and hang on. Good advice if you have rope left. If not, and if what little bit of the rope you have left is unraveling as you squeeze, it may be time to grab hold of debt settlement or bankruptcy.
Spoiler alert: You won’t enjoy either one. Debt settlement and bankruptcy are considerations only for consumers who cannot budget their way out of debt, even after slashing expenses and adding second-job income; cannot score some sort of debt consolidation loan, including a cash-out refinancing of their homes; and don’t qualify for debt management programs offered through nonprofit credit counseling companies. If you have not explored any of the avenues mentioned above, look into them before reading further.
However, if you’re at the brink of disaster, the thing to do is choose the wisest of available options. Selecting the right option for you begins with knowledge. And that begins here.
Let’s first acknowledge the slim similarities between debt settlement and bankruptcy: Each is designed to erase or forgive certain types and certain amounts of debt.
Also, at the end of each, your credit score will have absorbed a hammering.
That’s pretty much it. Beyond that, the two processes are remarkably different animals.
Personal bankruptcy falls, generally, into two types: straight liquidation of assets (Chapter 7) and reorganization (Chapter 13). Both go through the court system where a judge, ultimately, decides the outcome. Both also become part of the public record.
By contrast, debt settlement most often is a private negotiation between someone representing you — an attorney or debt settlement company — and your creditors. Debt settlement is a private transaction, though it is reflected on your credit report.
Once you have qualified for bankruptcy (even if your financial straits are dire, bankruptcy is not guaranteed; more about that below), creditors must stop hounding you for money.
That’s not the case with debt settlement. During the process — usually between 24 and 48 months — collection calls and mail demands continue, along with late and, possibly, over-limit fees continuing to accrue, with no guarantees they’ll reach successful outcomes. For this reason, debt settlement can end in bankruptcy anyway.
Debt settlement — also known as debt negotiation and debt arbitration — must never be confused with credit counseling and debt management programs. In debt settlement, you or your representative attempt to get creditors (usually credit card issuers) to accept a portion of the total balance as payment in full.
Individuals can try negotiating for themselves if they have access to substantial amounts of cash. The cash will be used to pay a substantial portion of their account balances — somewhere in the neighborhood of 40-70 percent.
When cash is scarce, debt settlement candidates turn to outside representatives who usually take the following steps to reach a settlement:
- Put their clients on a budget
- Order them to make no more payments on their unsecured (credit card, medical, personal loan, even student loan) debt
- Order regular deposits to be placed in a dedicated, or escrow, account
- Use the accumulated money (usually gathered over a 2-4 year period) to make an offer to settle the debt.
- Pay themselves. Debt settlement company fees could be as much as 20%-25% of your original debt.
Debt settlement can be more lengthy than bankruptcy, and will still damage your credit score. If you need immediate relief or do not have the ability to pay monthly fees, bankruptcy may be the best (or only) solution.
Additionally, a bit of homework is encouraged. “Not all debt settlement companies are created equal,” says Liverpool, N.Y.-based credit industry analyst Greg Mahnken. “Be sure to read reviews and understand all of the costs and terms of your agreement before enlisting a debt settlement company to help you.”
Pros of Debt Settlement
There definitely are some things to like about debt settlement, such as:
- If you’re organized and persistent, you can attempt debt settlement on your own. Talk to your creditors; explain your situation; attempt to work out terms. The fees you save can be substantial.
- If, instead, you require representation and all goes well, you can be clear of your unsecured debt in 24 to 48 months, at a fraction of what you owed — somewhere between 25%-50%.
- You won’t owe an add-on fee as each debt is settled; that’s already worked into your escrow account deposits.
- States regulate the debt settlement industry. Know your state’s laws regarding upfront disclosure of fees and services, as well as the risks and benefits.
- Harsh as it is, debt settlement can mean avoiding bankruptcy, which means, among other things, your plunge into fiscal calamity will not become public record.
Cons of Debt Settlement
- While you’re building your debt settlement war chest, collection contacts — calls, mail, email — will not cease, and they will not be polite.
- If your debt to any one lender is substantial — $5,000 or more — you might get sued, and if you lose in court, your wages could be garnished and/or your assets seized.
- Beware of false promises. The Federal Trade Commission lists some warning signs: upfront fees required; promises of a “new government program” that bails out credit card debtors; any sort of guarantee. There is no law saying the creditor must accept your offer.
- Your credit score will take a beating, and the settlement will remain on your account for seven years from the date of the initial delinquency. (Chapter 7 bankruptcy, however, lasts three years longer.)
- The IRS considers the amount of forgiven, canceled, or discharged debt as regular income. You will receive a 1099-C form and, unless you meet an exclusion or exception (rare), you’ll be on the hook for taxes to be paid by April 15 of the year following the settlement.
- Because some creditors refuse to work with debt settlement firms, you still might wind up with ballooning, fee-burdened debt that forces you to file for bankruptcy.
- You may drop out before the program is complete, leaving you with larger debts.
- It’s highly likely creditors with whom you settle will close your account completely.
Debt Settlement Fees
Debt settlement firms collect a percentage of your total (enrolled) debt, or the debt settled, depending on their arrangement with you. Most base their fees on the debt settlement, generally between 15%-25%.
Keeping it simple, if the company eliminates $10,000 in debt and charges a 25% fee, you’ll pay $2,500. Because your rep knows you’re not a reliable credit risk, that fee will come straight from your escrow account (managed by a third party that typically charges fees).
Make certain, before you sign on, you know whether you’ll be charged based on your total debt, or the amount of the debt reduced. The difference could be staggering.
Understand, too, the effect of late payment fees, over-balance charges, and other penalties listed in the fine print of your lending agreement.
Who It’s Best For
Simply put, if you have a mountain of unmanageable debt and bankruptcy is not an option — you can’t qualify for bankruptcy, or you absolutely cannot bear the stigma — debt settlement could be your best option.
That’s certainly true if you have access to substantial sums of money (the do-it-yourself model), or you have the stomach for keeping creditors at bay while you amass the cash to make credible offers.
Chapter 7 Bankruptcy
Also known as “liquidation bankruptcy” or “straight bankruptcy,” Chapter 7 filings tend to be what we have in mind when talk turns to bankruptcy.
You gather your financial records — bank statements, loan documents, pay stubs, credit card statements — and complete a bankruptcy petition, statement of financial affairs, schedules, and other required documents to be filed with the court.
Once approved, your assets — except for certain “exempt” property retained to assist your “fresh start” — are sold by a court-appointed trustee, with the money distributed to creditors who have filed legal claims. However, most Chapter 7 cases result in no assets being sold.
In the end, the debts addressed by your straight/liquidation bankruptcy (exceptions apply) vanish.
“Bankruptcy,” says attorney and CEO of LegalAdvice.com David Reisher, “provides considerable relief for anybody overwhelmed with unsustainable levels of debt.”
Pros of Chapter 7 Bankruptcy
The feeling of financial relief is one positive with Chapter 7 bankruptcy, but not the only one:
- Successfully completed, Chapter 7 is a clean way to achieve precisely what bankruptcy laws were designed to do: give the bankrupt a fresh start.
- Chapter 7 is fairly quick, usually taking between three and six months to complete.
- Filers get immediate relief from debt collectors. Calls and other contacts cease.
- By and large, your debts will be erased.
- You will not have to pay into a lengthy repayment plan.
- Your wages will not be garnished.
- If your credit has gone seriously south — like below 600 — your credit score actually will improve substantially in a matter of months.
- Once your bankruptcy is discharged, you can begin to re-establish credit worthiness by using a secured credit card and/or being added as a user to someone else’s credit account, and sticking to a budget.
- You can prevent your utilities from being shut off for nonpayment.
- You can avoid a foreclosure on your mortgaged home, or stop a tax deed sale.
- Bankruptcy’s “immediate stay” provision means you may be able to prevent your car from being repossessed. You may even be able to restructure your car loan in some cases.
Cons of Chapter 7 Bankruptcy
There are many and each needs your consideration.
- You have to qualify. Chapter 7 bankruptcies have a means test for household income and financial investments.
- If you’ve managed to keep your credit score in the good range — above 700 — it’s bound to suffer.
- You’re limited to the number of times you can file — no more than once every eight years. (Chapter 13 filers must wait four years before they can opt for Chapter 7.)
- Chapter 7 bankruptcy goes on your credit report and stays for 10 years. Because it’s a court proceeding, it also becomes public record.
- Generally, student loans cannot be eliminated or even modified in bankruptcy.
- Only tax debts that are older than three years can be discharged, but you’ll have to demonstrate you didn’t deliberately dodge the tax man.
- Depending on your state’s laws, your valuable assets — including an expensive car, jewelry, investment accounts, even property — probably will be liquidated to help pay your creditors.
- Everyone to whom you owe money — even relatives and friends — will be alerted to your filing.
- The trustee appointed to your case will review your financial history for signs of fraud. Selling assets just before you file for bankruptcy in an effort to move them off your books and keep them out of the clutches of the creditors, or unloading assets for less than they’re worth can get you into legal trouble.
- If you have cosigners on loans, they could wind up being on the hook for the debts you discharge. You owe them fair warning; they’ll get notice once you file.
Chapter 7 Fees
There’s a bitter irony about personal bankruptcy: You may be too broke to afford it.
Chapter 7 bankruptcy can be pricy. Court fees run $338. The average lawyer’s fee tops $1,100, with some cresting above $3,000. (You want professional representation; filers who represent themselves are far less likely to get the debt relief they seek.)
Take it from a pro:
“Lawyers are baffled by clients,” says Dai Rosenblum, who has practiced bankruptcy law in rural western Pennsylvania for over 25 years. “If someone is leaking blood, they don’t hesitate to go to a doctor. But if they’re leaking money, they won’t go to see a lawyer except as a last resort.
“Without legal advice,” Rosenblum says, “many take assets that are completely exempt, such as 401(k)s, and pay on debt that they don’t have to.”
Because a successful Chapter 7 filing wipes out most of a consumer’s debts, attorneys usually require payment up front. Otherwise, in most states, their fees may be uncollectible.
Check with the court to see about having fees waived, or arranging a payment plan. Find out whether your state allows making other than upfront payments to your attorney.
Again, if you have any doubt whether personal bankruptcy is right for you, check with a nonprofit credit counseling service first.
When to Consider Chapter 7 Bankruptcy
Chapter 7 works best for people who:
- Own little property or other valuables
- Lack substantial liquid financial assets (stocks, bonds, mutual funds)
- Have household income that doesn’t exceed the state median for family size
- Have substantial credit card balances, personal loans, and medical bills, because these will be wiped clean.
“The pros are low cost, over in a few months start to finish, and in a weird way, bankruptcy improves your credit,” Rosenblum says.
“All the debt that used to be on your credit report goes away forever,” he adds. “This tells a potential new lender that it will be easier, not harder, to make future payments.”
Chapter 13 Bankruptcy
In Chapter 13 bankruptcy — also called “a wage earner’s plan” — consumers do not see their debts wiped clean; instead, they are reorganized under a repayment plan that stretches from three to five years. Some creditors may be repaid in full; some may not.
Similar to a debt management plan, a Chapter 13 bankrupt pays a monthly sum to a trustee, who, in turn, distributes payments to creditors according to priorities set by the court.
“Because you pay back at least some of what you owe,” says Gina Pogol, a personal finance specialist with MoneyRates.com, “it’s considered a bit more respectable when you apply for credit in the future.
“Chapter 13 bankruptcy offers all of the benefits of a debt settlement plan, but you also get tax-free debt forgiveness, all interest and fees stop piling up, collection efforts stop and when you’re finished, you are free of debts.”
Pros of Chapter 13 Bankruptcy
Debtors who earn too much to qualify for Chapter 7 may yet score bankruptcy protection under Chapter 13. This means, among other things, calls and other contacts from creditors and collections agencies stop the moment the application is filed. Other plusses include:
- You get time to pay back your creditors, oftentimes with lower payments than you faced before declaring bankruptcy.
- Once your plan is complete, creditors who were not repaid in full cannot pressure you into making them whole.
- Under Chapter 13, a debtor has the length of the plan to catch up on past-due amounts owed on houses, vehicles, or loans secured by collateral. Repossession schemes stop under Chapter 13, and the valuables need not be liquidated as they would in a Chapter 7 filing.
- Through a Chapter 13, you may be able to renegotiate secured debts such as a car loan and in some cases can pay a lower interest rate and lower car payment.
- Chapter 13 filers also have the life of their plan to pay overdue income taxes and domestic support obligations such as child support and alimony.
- Chapter 13 protects the debtor’s cosigners on personal loans.
- In a Chapter 13 case, the debtor may be allowed to pay the bankruptcy attorney’s fee in an installment plan, rather than in advance.
- Unlike Chapter 7, which limits the frequency of filing, you may file for a Chapter 13 plan repeatedly.
Cons of Chapter 13 Bankruptcy
- It can take as many as five years to repay your debts.
- Your “disposable” income — that money you have after necessities are paid — is obligated to payments for the duration of the plan.
- Your credit score will take a massive hit.
- Bankruptcy debtors lose their credit cards which exist on the date they file.
- Like Chapter 7, Chapter 13 cannot get you out of student loan debt (although it may result in some restructuring).
- Chapter 13 bankruptcy debtors still have to make payments for domestic obligations, such as alimony and child support.
Chapter 13 Fees
The filing fee for a Chapter 13 bankruptcy is $313. There’s also a credit counseling charge that runs around $50 or less, plus a debtor education course (also $50 or less) to receive a discharge.
Bankruptcies are legally complicated. Navigating through a Chapter 13 on your own is ill-advised, but an attorney will be costly, somewhere between $2,500 and $6,000. Luckily, the structure of Chapter 13 bankruptcy allows the arrangement of a payment plan.
If you’re particularly squeezed, check with the local bar association about lawyers who do pro bono (free) representation. Also try getting in touch with a nearby legal aid office.
When to Consider Chapter 13 Bankruptcy
Chapter 13 allows debtors to catch up on missed payments while holding on to personal property, such as a home or a car. Chapter 13 also allows debtors to hold onto “nonexempt” property — precious valuables that would have to be liquidated to pay creditors in a Chapter 7 filing.
In short, if you have above-the-median income, you could meet your obligations if they were reorganized, and there are certain things with which you cannot bear to part — your inherited Rolex or vintage Corvette — but you’re otherwise in way over your head, Chapter 13 is for you.
Debt settlement only works if all the creditors are willing to participate. If not, you might still have to file for bankruptcy, which treats all creditors as equals. The bankruptcy trustee could increase your monthly payments to take care of the earlier settlements. As a result, Chapter 13 monthly payments might be lower than the combined monthly payments from debt settlements.
Consider Your Options
At this point, you may feel that neither bankruptcy nor debt settlement is the solution for you. And you may be right. A debt consolidation loan may be what you need. Also, a debt management plan enables you to pay off your debt because a credit counselor negotiates with your creditors to reduce your interest rate, waive fees and create a payment plan that works. If you want to explore all your debt relief options, speak with a credit counselor.
About The Author
Max Fay has been writing about personal finance for Debt.org for the past five years. His expertise is in student loans, credit cards and mortgages. Max inherited a genetic predisposition to being tight with his money and free with financial advice. He was published in every major newspaper in Florida while working his way through Florida State University. He can be reached at [email protected].
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