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Debt Settlement Vs. Bankruptcy: What Do You Need to Know?

Written by Banks Editorial Team

Updated April 22, 2021​

3 min. read​

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Debt Settlement Vs. Bankruptcy

Learn more the differences between debt settlement Vs. bankruptcy. When you’re in debt, it can feel like there’s no way out. A divorce, illness, or job loss can result in an otherwise financially stable family falling further into debt than they could have imagined. Once this occurs, catching up on debt is often impossible since late payment fees, penalties, and other fees assessed by creditors can make the bill balloon to upwards of two times the original amount owed. This often leaves a debtor trying to decide whether they should file for bankruptcy protection or pursue debt settlement options. Unfortunately, while neither of these is ideal, it may be the only way out from under staggering debt.

The first thing you need to do before deciding which option works best for your needs is to understand the difference between bankruptcy and debt settlement. The first thing you should be aware of is the difference between the two types of bankruptcy: Chapter 7 and Chapter 13. Chapter 7 bankruptcy requires a debtor to pass a “means” test while Chapter 13 bankruptcy reorganizes debt. Therefore, if you are ineligible for Chapter 7, be aware that, in some instances, Chapter 13 may allow more flexibility than debt settlement.

Let’s review the differences between debt settlement vs. bankruptcy.

Chapter 13 Debt Settlement Vs. Bankruptcy

When a debtor files Chapter 13 bankruptcy, they submit a reorganization plan to the bankruptcy court. Over a term of three to five years, you would make regular payments to the bankruptcy trustee who then pays creditors on your behalf. Since this process is time-consuming, it is often not a good option for a lot of debtors simply. Not only does it take a long time, but your credit report will reflect the bankruptcy for the term of the repayment plan and remain on your credit for seven years from the date of your original Chapter 13 bankruptcy filing.

Debt settlement often involves a lump sum payment to a creditor. In return, they “forgive” the remainder of the debt you owe them. There are some things you should be aware of when using this option, including the fact the creditor may report the debt as settled for less than owed on your credit report. In addition, you may also be liable to pay taxes on the amount of debt that the creditor forgives.

In some instances, a debt settlement company can help you negotiate with the creditor to change the language they place on your credit file. For example, some creditors may be willing to state your bills were “paid as agreed” rather than “paid for less than the amount owed.” This may be beneficial to you when you are rebuilding your credit.

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Deciding Between Debt Settlement Vs. Bankruptcy

Everyone has a different history behind their debt, and may people feel they are unable to repay the full amount they owe. As a debtor, you should review all your options carefully before determining if debt settlement options work best or if you should file bankruptcy. If you decide to work with a debt settlement company, you should do your research and look at the following:

  • Fees to be Paid: A debt settlement company charges their clients fees for resolving the debt. In some cases, the fees will be a percentage of the amount by which they are able to reduce the total amount you owe. Additional fees may include monthly installment payments as well as fees to maintain a savings account while you accrue funds to pay your creditors.
  • Predicted Outcomes: Debt settlement companies should be able to tell you what potential outcomes there are for your specific situation. Remember, your creditors do not have to accept any settlement offers, so it is important that the company lets you know how they have performed when working with certain creditors.
  • Ask About Tax Implications: Creditors do not always report the difference between the amount paid and the amount originally owed to the IRS. Make sure you ask the debt settlement company how this is handled with various creditors.

When Debt Settlement Makes Sense

If you are already behind on your debts and you can borrow or take money from your home equity or other cash on hand to pay down debt, you should consider debt settlement instead of bankruptcy. Remember, settled accounts will remain on your credit report for a period of seven years from the date of the original delinquency. For most debtors, this will be less time than a bankruptcy filing will stay on your credit.

Since no two situations are identical, deciding between debt settlement vs. bankruptcy is a personal decision. Before you decide which is right for you, make sure you do your research. If you decide on debt settlement, make sure you use a well-respected debt settlement company and that you understand their full terms and conditions before you sign a contract with them.

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