Debt Settlement vs Bankruptcy

Jason SteeleUpdated July 7, 2023

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When you have debts that you can’t make the payments on, then you’re probably desperate to find the right solution. Two ways out of this problem are bankruptcy or debt relief from a settlement, but they are very different.With debt settlement, either you or a third party negotiate so you can pay less than what you owe. Bankruptcy, on the other hand, is a legal process where you petition to get your debt discharged or get on a repayment plan. Below we highlight different aspects of debt settlement vs. bankruptcy and how debt relief vs. bankruptcies may provide potential solutions for debt relief.

Understanding Debt Relief

Debt relief is when a borrower receives loan forgiveness or a loan modification that makes it easier for a borrower to manage his or her debt. The purpose of debt relief is to ease the financial burden on a borrower who may be facing economic hardship. Debt relief can come in different forms, including bankruptcy or debt relief from a settlement.Borrowers may request debt relief for the following reasons:

Excessive debt-to-income ratio

Experiencing financial hardship

In need of a fresh start

You may seek professional advice when considering debt relief options. The U.S. Department of Justice maintains a list of approved credit counseling agencies by state that may help you find solutions for debt relief.

Debt Settlement Explained

Debt settlement is done outside the supervision of the courts. You can attempt to settle your debts yourself, or you can pay a debt settlement company to do so on your behalf.With debt settlement, you may be asked to suspend payments to your creditors, which can cause you to incur interest and penalties while hurting your credit score. And there’s never any guarantee that debt settlement negotiations will be successful. But when it succeeds, you may end up paying less than the total amount that you owe.There are pros and cons of debt settlement to consider. If you’re exploring debt settlement as a possible solution, here’s what to know:

Debt settlement may potentially have a negative impact on your credit score

Your creditors have no obligation to reach a debt settlement agreement with you

Any loan forgiveness you receive as part of a debt settlement agreement may be subject to income taxes

With debt settlement, you don’t declare bankruptcy, so you may not incur court fees

Debt settlement is not a public process like bankruptcy

With debt settlement, you may end up paying only a fraction of the amount you originally owed

The debt settlement repayment process can be quicker than it is with Chapter 13 bankruptcy, where repayment plans extend from three to five years

Recommended: What Are Settlement Loans?

Bankruptcy Overview

Bankruptcy is a court-sanctioned process where debts are either discharged or a payment plan is put into place.In Chapter 7 bankruptcy, your debts are eliminated, but it could require the sale of assets like your car or house. With Chapter 13 bankruptcy, you can keep your home, but you must partially repay your creditors over a period of three to five years. Sole proprietors may choose Chapter 7 or Chapter 13 when filing for bankruptcy.Anyone who has gone through bankruptcy will have severely damaged credit for seven to 10 years, depending on which type of bankruptcy they filed for. The process of bankruptcy can also lead to incurring significant legal fees.If you’re exploring bankruptcy as a possible solution, here’s what to know:

You may need to hire an attorney when filing for bankruptcy, which can be costly

Under Chapter 7 bankruptcy, you must list joint checking accounts as assets

Filing for bankruptcy may cause your credit score to plunge

When you file for bankruptcy, it can immediately prevent creditors from sending you to collections

When you file for bankruptcy, a bankruptcy trustee who is an officer of the Department of Justice is appointed and represents your estate in the bankruptcy proceeding

When you file for bankruptcy, your assets may be protected from your creditors to some degree, depending on the laws of your state

You won’t owe any taxes on debts that are discharged by bankruptcy

In most cases, federal student loans cannot be discharged in bankruptcy. To do so, you would have to file a separate action known as an adversary proceeding and prove that paying back the loans would be an undue hardship. Federal lawmakers have set this higher bar for discharging student loan debt compared with other consumer debt, according to the Justice Department.The Department of Justice in November 2022 announced a new process that can make it easier for debtors to discharge student debt in bankruptcy. The process allows debtors to complete an attestation form to help the Justice Department assess whether the debtor meets the undue hardship standard. Attorneys for the Justice Department would then review multiple factors before recommending whether a debtor should receive a complete or partial discharge of student loan debt.

Comparing Debt Settlement and Bankruptcy

When evaluating debt settlement vs. bankruptcy, your personal circumstances may dictate whether either option is right for you. Debt settlement is an agreement between you and your creditors, while declaring bankruptcy is a court-sanctioned process. Debt settlement may require partial repayment, whereas bankruptcy may completely discharge some debts. Bankruptcy cases take place in a federal Bankruptcy Court, unlike debt settlement agreements that typically happen outside of the legal system.While you could have a portion of your debts forgiven with debt settlement, you may have to pay taxes on that amount. Also, debt settlement companies can be expensive, and the process can damage your credit.Chapter 7 bankruptcy can be the best solution for those who are unable to reach a satisfactory debt settlement. However, there are negative impacts of Chapter 7 bankruptcy to consider, like the seizure of property and the fact that it stays on your credit report for up to 10 years.

Debt Relief vs Bankruptcies

You may consider several debt relief options, including bankruptcy or debt relief through a settlement agreement. You may also request a loan deferment, which is a temporary break from making your loan payments.Consumer debt can come from student loans, auto loans, personal loans, mortgage loans, and credit cards. Here are some additional debt relief options you may consider:

Debt consolidation loans

Loan modification

Voluntary repossession

You may compare debt consolidation loan rates if you’re interested in consolidating high-interest credit card debt with a personal loan.Having a bankruptcy filing on your credit report can make it more difficult to get approved for consumer lending products. Loan approval is never guaranteed, but there may be some banks that work with bankruptcies for personal loans if you apply with a cosigner or co-borrower.

Making an Informed Decision

Whether you choose bankruptcy or debt relief from another option, evaluating the pros and cons can help you make an informed decision that’s right for you.Bankruptcy typically involves hiring an attorney and going through court proceedings, which can be expensive. A successful bankruptcy can erase some debts but may severely damage your credit for up to 10 years. With bankruptcy, you won’t have to pay taxes on the debts discharged.Debt settlement may involve partial loan forgiveness, but the amount that’s forgiven is considered taxable income, so you may owe income taxes on those savings. However, debt settlement doesn’t become public record, and it won’t stay on your credit report for 10 years.As mentioned earlier, you may consider debt consolidation loans or other alternatives to bankruptcy. Creditors have no obligation to negotiate a debt settlement agreement, and filing for bankruptcy can be an option of last resort if you’ve exhausted all other options.

The Takeaway

Debt settlement and bankruptcy are two very different ways of handling debts that you’re unable to pay off, and each has its advantages and drawbacks. As you’re weighing debt settlement vs. bankruptcy, it’s important to keep these pros and cons in mind, and remember the financial implications of either choice.If you need a debt consolidation loan, Lantern by SoFi can help. Just fill out a simple form and compare personal loan rates in our marketplace.Simplify searching for personal loans and find prequalified offers using Lantern.

Frequently Asked Questions

Is a settlement the same as bankruptcy?

Is debt settlement good or bad?

Does settling a debt hurt credit?

How much will creditors accept as settlement?

Photo credit: iStock/Andrii Yalanskyi

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About the Author

Jason Steele

Jason Steele has been writing about credit cards and award travel since 2008. One of the nation's leading experts in this field, he has contributed to dozens of personal finance and travel outlets and has been widely quoted in the mainstream media.

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