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Managing overwhelming debt can be challenging, and finding the right solution often depends on your financial situation and long-term goals. Two common strategies for addressing serious debt are debt settlement and bankruptcy — each with distinct processes, benefits, and consequences. Understanding how they work can help you make a more informed decision.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:
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. 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
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
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 nearly all cases, federal student loans survive bankruptcy unless you initiate an adversary proceeding — which is a separate lawsuit — and demonstrate that repaying the debt would impose an “undue hardship” on you. Unlike other consumer debts, Congress has intentionally set this high bar for discharging student loans.
Comparing Debt Settlement and Bankruptcy
When evaluating debt settlement vs. bankruptcy, your personal circumstances may dictate which 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:
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, 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 a 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?
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.
