Should I File for Bankruptcy or Use Debt Settlement?

If the thought of filing bankruptcy makes you uncomfortable, you might want to try negotiating with your creditors.

When someone’s finances become too much to handle, it’s common to look for other ways to manage debt—especially given that bankruptcy still carries an uncomfortable stigma for many people. If you fall into that category, you might find success negotiating a lower payoff with creditors by going through a debt settlement company. But, before you decide, it’s wise to understand the advantages of both bankruptcy and debt settlement so that you can make an informed decision.

Bankruptcy Basics

Bankruptcy will effectively get rid of (discharge) many types debts, but not necessarily everything that you owe. You’ll likely want to start by reviewing your debts, and determining whether bankruptcy would provide the relief you need.

(For more information, see Bankruptcy Discharge: Which Debts are Wiped Out?)

Also, in a Chapter 7 bankruptcy, you might have to give up property that you can’t protect (exempt), but, you won’t have to repay your creditors. By contrast, you’ll be able to keep your property in a Chapter 13 bankruptcy, but you’ll have to repay your creditors some amount in a three- to five-year repayment plan.

(To learn more about the differences between the chapters, start by reading When Is Chapter 7 Bankruptcy Better Than Chapter 13?)

About Debt Settlement Companies

A legitimate debt settlement company will help you set up a plan to manage your debts. Typically, you’ll make regular payments to the company, who will hold the funds in escrow while negotiating with your creditors.

However, the debt settlement industry is rampant with scam artists operating on shaky financial footing. Even though they promise to keep client funds in escrow to pay settled debts, many don’t, and when the company folds, clients learn that the company has used their deposit to pay for marketing campaigns and operations.

Some red flags to look out for:

  • High up front or ongoing fees. You can expect the company to take their fee as a percentage of the money they save you when they negotiate a settlement with a creditor.
  • Promises to fix your credit score. Debt settlement companies can’t fix your credit score by removing negative information unless it’s inaccurate. Any promises to the contrary are based on a process that requires the company to dispute the information even if it’s correct. When you stop paying for the service, the negative entries will likely reappear.
  • Guaranteed results. Debt settlement companies cannot ensure that a particular creditor will settle any debt for any amount. They cannot even guarantee that they will remain in business long enough to settle your debts.

Even so, this isn’t to say that you can’t find a good company. Just do your homework.

Other Factors to Consider

Here are some other differences worth noting:

How Long Does the Process Take?

  • Bankruptcy. A Chapter 7 bankruptcy usually takes about four to six months. In a Chapter 13 case, you’ll propose a repayment plan that can last from three to five years, depending on whether your family income falls below or above the median income for your state.
  • Debt settlement.There’s no set time. It will depend on how long it takes you to negotiate a settlement amount and gather or save the money needed to pay it.

How Much Will It Cost?

  • Bankruptcy. You can expect to pay a court filing fee of $310 for Chapter 13 bankruptcy and $335 for Chapter 7 bankruptcy (as of August 2017); attorneys’ fees that vary by region and complexity of the case; and credit counseling and debtor education courses for $50-$100. You’ll also have to pay into a three- to five-year repayment plan in Chapter 13 bankruptcy.
  • Debt settlement. The cost will vary depending on the result of your negotiations. Most creditors eventually settle for 40% to 60% of the balance but will likely require you to pay that in a lump sum.

Protection from Creditor Action

  • Bankruptcy. Creditors cannot choose whether or not they participate in the bankruptcy case. It applies to all. Creditors cannot take action to collect their debts without the express permission of the bankruptcy court.
  • Debt settlement. Creditor participation is voluntary. Until you reach a settlement, creditors are free to take whatever collection action they’re allowed by law, including filing a lawsuit.

Effect on Credit

  • Bankruptcy. Negative information about your accounts will show on your credit report for seven years with an explanation that the debt was included in bankruptcy. Chapter 7 bankruptcy will appear on your credit reports for ten years from filing. By contrast, a Chapter 13 case will remain for seven years after filing.
  • Debt settlement. Negative information about your accounts will remain on your credit report for seven years, but the creditor should report that the account was “settled” or “paid settled.”

Tax Consequences

  • Bankruptcy. You won’t have to pay tax on a debt discharged in bankruptcy. The Internal Revenue Service doesn’t treat this type of debt as income.
  • Debt settlement. The creditor can report the unpaid debt on IRS Form 1099-C (cancellation of debt), which the IRS will treat as income unless certain conditions are met. Therefore, you stand to pay income tax on the forgiven amount.

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