Debt settlement vs. bankruptcy: which should you choose?

Learn the differences between debt settlement and bankruptcy and which is more suitable for you

•

02 October 2023

Are you fighting the mighty adversary known as debt? Are you trying to find the right strategy to defeat this menacing foe?

The following article will detail two potent weapons in the arsenal against overwhelming debt: bankruptcy and debt settlement. While both are intended to alleviate financial strain, they are distinctly different.

So, what exactly is the distinction between the two, and critically, why is bankruptcy considered the nuclear option?

What is debt settlement?

Debt settlement is a debt relief solution available to individuals facing financial hardship. It involves negotiating the debt owed with a creditor to make it easier for the debtor to pay off their liabilities.

While the steps can vary, here’s what a typical debt settlement process looks like.

Decide who will negotiate: Choose whether you’ll represent yourself in debt settlement negotiations or use the services of a debt settlement company. Debt settlement companies can help negotiate with creditors on your behalf. Because of their experience and expertise, these services may help increase the odds of reaching a favorable settlement.
Negotiate: The debtor or a debt settlement company will initiate the discussion with creditors.
Debt reduction: Assuming an agreement is reached with the creditor, the debtor pays the negotiated, reduced amount. For example, the creditor may agree to a 50% reduction in the balance owed.
Payment: The negotiation may involve the debtor paying a new, lower, lump-sum amount to clear their debt. Alternatively, the negotiation may simply lead to a new payment plan based on the reduced amount.

Pros and cons of debt settlement

Pros

It can provide financial relief by reducing the overall amount owed.
While it can initially hurt it, debt settlement can help improve your credit score over time.
It can help stop aggressive debt collection calls.
In some states, consumers are provided legal protections when settling debt.

Cons

It can harm your credit score initially.
Debt settlement companies often charge steep fees for their services.
The IRS may deem forgiven debt as taxable income. For example, if $20,000 of debt was forgiven, you may be taxed on this value as if it were earned income.
It can take several years to conclude, and there’s no guarantee of success.

What is bankruptcy?

Bankruptcy is a legal procedure. It allows individuals or businesses facing financial distress or insolvency (the state of being unable to cover debt payments) to eliminate a portion of, or in some instances, all, outstanding debt.

There are a couple of bankruptcy types—each with its own benefits and quirks.

Chapter 7 (liquidation)

Suitable for individuals or businesses.
With Chapter 7 declarations, assets are sold to repay creditors. Afterward, any remaining debts are discharged (canceled).
For individuals, specific properties may be exempt from the required sale.

Chapter 11 (reorganization)

Typically used by businesses.
It enables companies to continue operating while restructuring their debt in order to reach profitability.

Chapter 13 (wage earner’s plan)

Intended for individuals with regular income (i.e., a salaried job).
Usually, a payment plan will be initiated that will see debts cleared in part or full over three to five years.

Pros and cons of bankruptcy

Pros

It can lead to the discharge of certain obligations or offer a pathway to repay the debts in a structured and manageable way.
Filing for bankruptcy triggers what’s known as an ‘automatic stay.’ This simply means actions by creditors, like harassing phone calls, are paused.
It can offer individuals a fresh financial start.
Some assets may be exempt from liquidation.
In some scenarios, a bankruptcy declaration can help prevent your home from being foreclosed.

Cons

Bankruptcy can severely damage your credit score and remain on your credit history for up to a decade.
After filing, you may have difficulty obtaining new credit. If you do secure loans, they may come with higher interest rates.
Chapter 7 bankruptcy may require you to sell some of your property to repay creditors.
There is a stigma attached to bankruptcy.
Filing can involve costly court and attorney fees.

Debt settlement vs. bankruptcy

As you’ve likely gathered by now, debt settlement and bankruptcy are two distinct routes individuals can take when drowning in overwhelming debt.

Debt settlement involves negotiating with creditors to reduce the overall amount you owe, while bankruptcy is a legal process that can lead to discharged or restructured debts.

Think of it this way: debt is your enemy, and you’ve declared war. Both debt settlement and bankruptcy are strategies and weapons you can leverage in that war.

If debt settlement is conventional warfare, then bankruptcy is the nuclear option.

Countries typically don’t jump straight to the nuclear option, nor should you. That's because the nuclear option has consequences.

In this case, it can mean a substantial and lengthy negative hit to your credit health. As a result, it’s imperative to exhaust all solutions, like debt settlement, before considering bankruptcy.

Example: When debt settlement is the better option

Imagine Johnny has accumulated $25,000 in credit card debt. The debt racked up due to unexpected medical expenses and a period of unemployment.

Although Johnny is once again gainfully employed, he’s struggling to cover his living expenses and pay down his outstanding debt at the same time. He earns enough to cover minimum payments, but the high interest rates mean he’s barely making a dent in the principal amount.

Johnny would likely be a suitable candidate for debt settlement. By negotiating with his creditors, he can reduce the amount he owes and find a payment plan that fits his budget. This means he can avoid the more severe step of declaring bankruptcy.

Example: When bankruptcy is the better option

Now consider Melinda. She’s accumulated a $100,000 debt from a failed business idea. Her income has dropped substantially, and she can no longer make the minimum payments on her debt obligations.

Recently, Melinda began suffering from a medical condition that prevents her from working. She doesn’t expect her income to rise significantly any time soon.

In this scenario, debt settlement would be insufficient. Because Melinda is drowning in debt and can barely afford other basic living expenses, declaring bankruptcy is likely her best option.

If successful, Melinda can discharge most, or potentially all, of her outstanding debt balances. This would give her a fresh start and a chance to build a more stable financial future.