At a Glance
These options should only be considered if you’ve tried everything else and cannot pay down or eliminate your debt. There are a variety of options available to you before reaching this point, so doing research and exploring all options is a key first step in deciding if settling or bankruptcy is right for you.
If you have no other options, understanding the pros and cons of filing bankruptcy or settling debt is critical in deciding which is right for you and your financial situation. In this article, read about:
Is it better to file bankruptcy or settle debt?
To know whether it’s better to file bankruptcy or settle your debt, you must understand what each is, and the pros and cons of both. Ultimately, it depends on your personal financial situation and goals.
What is bankruptcy?
Debt can be overwhelming. And if you’ve spent months or years trying to pay it off with little or no success, you may be considering filing bankruptcy as your last option. Filing bankruptcy enters you in a legally binding process that will help you get rid of your debt, but there are also negative consequences to be aware of depending on your financial situation and goals.
There are two most common types of bankruptcy filings: Chapter 7 and Chapter 13.
- Chapter 7: When you file Chapter 7 bankruptcy, you’ll file a petition with the bankruptcy court in your area. Include a detailed outline of your assets and liabilities, income, expenses, statement of financial affairs, tax returns, and any other documentation proving your financial circumstances and supporting your bankruptcy filing.
The court will then determine which of your assets to sell in order to repay your creditors, and the remaining debt will be discharged (except for student loans, child support, taxes, and alimony). So, while not all of your debt will be cleared, most will be through the sale of your assets.
Note that not everyone qualifies for Chapter 7 since there is an income limit that you can not go over.
On average, filing Chapter 7 bankruptcy takes about three to four months to complete from start to finish.
- Chapter 13: When filing Chapter 13 bankruptcy, you’ll have a chance to keep more of your assets than Chapter 7, but also cancel some of your debt.
After you sell what assets you can, whatever debt isn’t discharged will be put on a three- to five-year repayment plan. Essentially, Chapter 13 acts like a consolidation loan, in which you make payments to a trustee who then will distribute those payments to creditors.
Unlike Chapter 7, which can be a quicker process, Chapter 13 filing can take many years since you’ll likely be paying back your debts through a repayment plan. The other primary difference is that unsecured debt that remains after the repayment plan will be discharged, meaning it goes away.
Regardless of which type of bankruptcy you file, the court will put an automatic stay order in place. Your debt creditors must stop calling you, any eviction processes must be halted, and foreclosure or repossessions must also stop (for the time being) so that you have some time to get your debt cleared and other finances in order.
Does bankruptcy clear all debt?
While filing bankruptcy does help clear some debt, it doesn’t mean all of your debt will be eliminated for good. This is because there are two types of debt, secured and unsecured, and they are treated differently.
Unsecured debt has no collateral, and is typically cleared by filing bankruptcy. Examples of unsecured debt include:
- Credit card debt
- Medical bills
- Overdue utility payments
- Personal loans
Secure debt uses your assets as collateral, and while the debt may be cleared after filing, you could lose the asset completely. An example of secure debt includes mortgage. For example, if you default on your mortgage, your home could be foreclosed and you’d lose the house.
Other debt that bankruptcy cannot clear includes:
- Child support
- Alimony obligations
- Most student loans
- Tax debts
- Other debts not listed in the bankruptcy papers you file
What is debt settlement?
When settling your debt, you’re partnering with an individual or debt settlement service and allowing them to negotiate your debts, which could include decreasing what you owe or settling some or all of your total amount. This company operates as an intermediary between you, the person owing the debt, and your creditor. They may:
- Create an account to consolidate all debt payment into one
- Order you to cease making debt payments
- Act as the primary point of contact for all creditors
- Negotiate on your behalf for a lower rate
- Work with creditor to set up settlement or payment plan
These settlements are typically for unsecured debts.
In most cases, you’ll be required to make regular deposits into an escrow-like savings account that is then put toward your lump-sum payment. They will then negotiate with the creditor, and reach an agreement for a settled amount. This may be that you’ve paid enough and don’t owe more, or you may owe a smaller amount that you can pay off faster.
Note that while the company is working to settle your debts, you may be asked to stop making debt payments. This can do serious harm to your credit score and reputation, while also piling additional fees, penalties and interest onto your outstanding debt. In the end, you may end up owing more than you did originally.
Additionally, you’ll likely owe high fees, even up to 25% of your original debt, regardless of whether or not they settle your debt.
Should I file bankruptcy or debt settlement?
Before considering filing bankruptcy or settling debt, be sure you exhaust all other options such as credit counseling, debt management plans, debt consolidation, debt repayment strategies, etc. Bankruptcy or settlement should be your last resort.
Whether you should file bankruptcy or settle your debt depends on your financial situation and goals, since each approach has positives and negatives.
When it comes to your own goals, ask yourself:
- What is the total monthly payment for each option?
- What is the length of time until I’m debt-free?
- What are my short- and long-term financial goals?
When filing bankruptcy, you’ll be protected from creditors and may be able to resolve your debts faster without paying taxes on the debt that was eliminated. However, your credit score will take a significant negative hit that may be difficult to repair. This may be the best option if you have a significant amount of debt and you’ve exhausted all other options.
- Filing Chapter 7 bankruptcy may also be best for those who don’t own a lot of property or valuable assets, lack substantial liquid financial assets, and have a low household income that doesn’t exceed the state median for family size.
- Filing Chapter 13 bankruptcy may be best if you have above-the-median income, could meet your obligations if they were organized differently, or you have assets you cannot give up.
When you settle your debt through a debt settlement program, you may be able to settle up to 80% or more of what you originally owed. However, your creditors do not have to accept your offer and you may end up having to pay all of what you owe anyway.
Plus, debt settlement companies often charge large fees, even if they aren’t successful in settling your debts. If you have some funds you can set aside, or don’t owe a significant amount of debt, negotiating your debt may be more favorable.
You may also consider debt settlement if you don’t qualify for filing bankruptcy.
Neither is a simple process, and it’s important to do your research before making a final decision. You may also want to consult a financial professional or certified credit counselor.
Commonly Asked Questions
Can I negotiate debt settlement on my own?
If you choose, you do not have to work with a debt settlement company to settle your debt with creditors. You can try to work out an agreement on your own by contacting your creditors and negotiating a lower rate or payment.
Is debt management better than bankruptcy?
Debt management plans can help you consolidate multiple debts into one payment that you’ll pay off monthly. In most cases, you’ll partner with a nonprofit credit counseling agency who will help you set up a three to five-year repayment plan, and they may help you negotiate a lower interest rate or eliminate other fees. This doesn’t affect your credit score nearly as much as bankruptcy, you’ll maintain your assets, and you’ll pay off the entire amount in the end.
What is debt consolidation?
Debt consolidation is combining all of your debts into one lump sum, then taking out one loan (with a lower interest rate) to pay it off. The lower interest rate can help save you money in the long run, and one payment makes managing your debts easier. These payments are also fixed, which makes them easier to budget.