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Debt Settlement Versus Bankruptcy: What's Right for You?

min read

Debt-settlement-bankruptcyIf your financial problems are serious, you might consider debt settlement or bankruptcy. Either solution is a last resort, and both can have long-lasting consequences. So it's important to make the right choice.

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Debt settlement and bankruptcy: what's the difference?

Debt settlement and bankruptcy are two methods for getting out from under overwhelming debt. The chief difference between them is that bankruptcy is a legal term. It's public, there are rules, and if the Bankruptcy Trustee allows you to file, your creditors have to accept it.

Debt settlement, on the other hand, is not public. While there are laws governing how debt settlement companies operate, your creditors do not have to participate. And there is no court - you negotiate the best deal you can, on your own or using a debt settlement company.

There are many other points you must know before deciding, but that is the main difference.

How debt settlement works

Debt settlement is a way to pay off your unsecured debts, like credit card balances, collections and personal loans, for less than the full amount owed. You can do this by ceasing your monthly payments for a while and saving them until you have a lump sum to offer in settlement. Or you can get a lump sum by borrowing or selling assets.

Once you have your money, you are ready to negotiate with creditors.

If you use a debt settlement company, you usually pay into an escrow account each month until you reach your target amount. Debt settlement companies cannot legally take payment upfront. You should receive a monthly statement showing how much money is on deposit and how much will go to your creditors (the rest is the fee to the company).

You (or your debt settlement company) attempt to reach an agreement with all creditors to discharge your obligations for less than the outstanding balance. At this point, the creditor may be more likely to negotiate and minimize its losses if it has not been paid for a few months.

How much can you save with debt settlement?

A study by the Center for Responsible Lending concluded that the average creditor settles for 48% of the amount due. If you hire a debt settlement company, its fee is typically 15%. You'll also owe taxes on the amounts forgiven by creditors because the IRS considers it income to you. So, if your tax bracket is 25% and you settle $20,000 of debt for $9,600, your bottom line looks like this:

  • Full balance: $20,000
  • Settled amount: $9,600
  • Debt settlement fee: $3,000
  • Taxes: $2,600
  • Total paid: $15,200
  • Saving to consumer: $4,800

It's important to get an accurate estimate of the after-tax effect of debt settlement. For some, the savings may not be worth the risk and hassle.

Related: Top 5 Money Problems and How to Solve Them

Debt settlement pros and cons

Debt settlement has both advantages and downsides compared to bankruptcy. Its drawbacks include:

  • You will be subject to collection efforts including phone calls and letters when you withhold payment from your creditors.
  • There is no guarantee that creditors will accept your offer.
  • Creditors can choose to sue you for payment.
  • Your credit score will take a beating - possibly more than with bankruptcy.
  • The IRS claws back a hefty percentage of your savings.

The advantages of debt settlement include:

  • There is no public record of your settlement. If your privacy is important to you, that can be very compelling.
  • You won't have to pay upfront to file as you would in bankruptcy.
  • There is no retainer to a bankruptcy lawyer.
  • You can protect assets that a bankruptcy court might force you to give up.
  • You can decline a settlement offer you don't like.

Debt settlement is not for the faint-hearted or anyone who is not desperate. It is stressful and costly. But sometimes necessary.

How bankruptcy works

Bankruptcy is a legal process designed to allow consumers to reorganize their payments or clean their slates and start over. There are two filings for individuals: Chapter 7 and Chapter 13.

Chapter 7 is the "clean slate" filing. The bankruptcy court examines your assets, income and debts. You must pass a "means test" showing that you really have no resources for repaying at least some of what you owe. This is not an easy standard to meet. Chapter 7 is the filing that most closely resembles debt settlement because you discharge your debts for less than you owe.

Chapter 13 is the "reorganization" filing. You'll submit your financial documents to a Bankruptcy Trustee. This person examines your filing and establishes a payment, which you will make every month for a number of years (usually five). At the end, if you make your payments as agreed, any remaining balances are discharged. Chapter 13 is more like a debt management plan than debt settlement because you make regular payments.

Related: Bankruptcy in Retirement

Chapter 7

If you pass the means test, the court takes your assets, sells them, and distributes the proceeds to your creditors. Whatever they get discharges your debts in full. The creditors have no choice. They also must halt collection efforts including phone calls and mail.

Note that you do get to keep some assets, depending on the laws of your state. This is "exempt" property. For example, an inexpensive car, tools for your work, clothing, some home equity and a retirement account. Non-exempt property can be taken and sold.

The average fee to file a Chapter 7 is $1,450 according to Nolo.com. The IRS does not consider amounts discharged in bankruptcy to be taxable income. The amount you save by filing Chapter 7 depends on how much debt you have and what your non-exempt assets total. If you owe $20,000 in credit card debt and own a $10,000 Rolex, kiss your watch goodbye. But you'll save the other $10,000, less your filing costs.

Chapter 7 is a public record and may stay on your credit report for ten years. However, the effect of a filing on your FICO score diminishes over time, and you may qualify for a mortgage in a year or two under some programs.

Chapter 13

In Chapter 13, you send in monthly payments, which the Trustee distributes to your creditors. Every year, you submit your taxes, and the Trustee may adjust your payment up or down. No interest or penalties accrue during your bankruptcy period.

The main risk with a Chapter 13 filing is that if you fail to complete it, you still owe the full remaining balances to your creditors. If they write off the balances, it becomes taxable income. You can also be sued.

The average fee to file a Chapter 13 bankruptcy is $3,000. If you filed Chapter 13 with $20,000 of debt, and the Trustee decided that you could pay $100 per month, you'd pay $6,000 over five years. You'd save $14,000, less your filing costs.

Related: Guide to Medical Debt

Debt settlement versus bankruptcy: how to decide

When deciding on debt settlement or bankruptcy, you'll look at these factors:

  • Can I afford a lawyer (or complete the bankruptcy filing on my own)?
  • How much debt do I have?
  • How important is my privacy?
  • Can I tolerate being harassed by my creditors?
  • What if my creditors won't negotiate?
  • Can I pay the taxes if I settle debt?

The ideal debt settlement candidate has a relatively small amount of debt to discharge, which would make bankruptcy too expensive. It would help to be in a low tax bracket. And it helps to have a thick skin and strong stomach.

The ideal candidate for bankruptcy does not mind filing publicly. He or she can afford to retain a lawyer and there is enough debt on the table that it's worth discharging it tax-free. Bankruptcy filers must be okay with the Trustee taking their non-exempt property in a Chapter 7 or dictating a monthly payment for a Chapter 13.

Finally, there is nothing to preclude you from attempting debt settlement first, then switching to bankruptcy if you can't get what you need from your creditors. The bankruptcy court then steps in and establishes a plan for everyone involved.

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