Debt settlement negotiates a reduced payoff with creditors, while bankruptcy is a court process that discharges or restructures debt. Both damage your credit and are generally last-resort strategies when you owe more than you can realistically repay.
Debt settlement may be the better path if you can afford some payments toward your debt. Bankruptcy, however, could make sense if your debts are more than what you can feasibly afford or you’re facing lawsuits from your creditors.
Understanding how debt settlement and bankruptcy work, along with their pros and cons, can help you determine which form of debt relief better suits your situation.
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What is debt settlement?
Debt settlement involves negotiating a reduced payoff with your creditors. If your creditor agrees, you’ll send off a lump-sum payment for less than what you owe to settle the debt. Debt settlement is most commonly used for unsecured debts, such as credit cards, personal loans, and medical bills.
If you owe $10,000 on a credit card, for instance, your creditor may agree to accept $7,000 to resolve the account. In this case, the remaining $3,000 would be forgiven.
Rather than pay a lump sum, you may instead arrange a term settlement. This involves making several payments over a set period of time until the agreed amount is settled.
Settling your debts can take two to four years, and comes with risks such as damaged credit. You may be able to settle a debt for as little as 50% of what you owe, but success isn’t guaranteed.
How does debt settlement work?
Debt settlement works in one of two ways: You can contact your creditors directly or hire a debt settlement company to negotiate on your behalf.
Debt settlement companies often charge fees of 15% to 25% of your enrolled debt. But they have expertise in this area and can communicate with creditors, so you don’t have to. If you’re comfortable handling negotiations on your own, you could opt for DIY debt settlement and save money on fees.
Either way, you’ll typically stop making debt payments and instead save up a lump-sum amount before starting negotiations. Your creditor may agree to settle the debt if you’re behind on payments, since they’d rather recover some of what you owe than nothing.
But missed payments will damage your credit score and lead to late fees and accruing interest. If the creditor refuses to settle, you could be facing an even higher balance and ruined credit. The creditor can also begin collection activities or file a lawsuit against you if you stop paying.
Am I taxed on forgiven debt?
If you’re able to settle your debt, you’ll have another cost to contend with in the form of a tax bill.
According to IRS rules, forgiven debt over $600 to be taxable income. If your creditor forgives $5,000, for example, you’ll owe income taxes on that amount. Take this potential tax liability into account if you’re considering debt settlement.
How does bankruptcy work?
Bankruptcy is a process that takes place in the courts. It can completely wipe out your eligible debts or create a reasonable repayment plan to help you get out of debt.
The process can be complex, so while you can file on your own, many consumers work with a bankruptcy attorney. You must file with a federal court and work with a trustee, who will review your finances.
There are two main types of bankruptcy: Chapter 7 and Chapter 13.
Chapter 7 vs. Chapter 13 bankruptcy
Chapter 7 bankruptcy can wipe out most types of unsecured debt, such as credit cards and medical bills. You must pass a means test (your income must fall below a certain threshold) to qualify, and the process usually takes four to six months.
You’ll generally hold on to your primary assets, but you may have to sell nonessentials such as a second car or valuables to pay back creditors.
Chapter 13 bankruptcy won’t wipe out your debts completely. Instead, you’ll get a court-ordered repayment plan for three to five years. If you still owe a balance after this time, the remaining amount may be discharged.
Chapter 13 is generally an option for consumers with a steady income who don’t qualify for Chapter 7.
Does bankruptcy stop wage garnishment?
During the bankruptcy process, the court can order an automatic stay that temporarily halts collection activities, wage garnishment, foreclosures, and lawsuits.
If your debts are discharged during bankruptcy, wage garnishment and other collection activities will not resume. If your debts remain after the bankruptcy proceedings, wage garnishment may resume.
Debt settlement vs. bankruptcy
Both debt settlement and bankruptcy come with significant financial consequences. Here’s how the after-effects compare.
How to decide between debt settlement and bankruptcy
Debt settlement may make sense if you can afford some payments on your debt and want to avoid court, but bankruptcy could be better for insurmountable debt or more urgent situations, such as lawsuits or wage garnishment.
You might consider debt settlement if:
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You’re able to save for a lump-sum settlement
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Your debt amount is relatively manageable compared to your income
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You want to avoid going to court or dealing with the public nature of bankruptcy
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Most of the debt you need to reduce is unsecured
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You’re not already facing lawsuits or wage garnishments
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You’ve fallen behind on payments by more than 90 days (or plan to, as most creditors won’t agree to a settlement before this point)
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You can negotiate with creditors yourself or are willing to pay the fees for a debt settlement company
Bankruptcy might be more applicable to your situation if:
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You have more debt than you can realistically pay back and little disposable income
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You’re facing lawsuits, wage garnishments, or foreclosure
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You need legal protection from collection activity
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You’ve already been unsuccessful with debt settlement
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You’re looking for a faster, more complete reset of your financial situation
Should I get professional help?
Debt settlement and bankruptcy usually come into play when you’re dealing with unmanageable debt on a limited income. Both options carry serious financial consequences, so it’s important to understand how they work before you move forward.
Working with a professional, such as a nonprofit credit counselor or bankruptcy lawyer, could help you determine the best path forward. A professional can review your financial situation, explain your options, and help you understand potential outcomes before you commit.