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Debt Settlement vs. Bankruptcy: The Differences and Similarities

Debt Settlement vs. Bankruptcy: The Differences and Similarities
Jason Steele
Jason SteeleUpdated May 26, 2022
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
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 debt settlement and bankruptcy, 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. Read on to learn more about debt settlement vs. bankruptcy, including bankruptcy vs. debt settlement pros and cons.

Bankruptcy vs. Debt Settlement: An Overview 

Before choosing between bankruptcy vs. debt settlement, it’s important to know more about what each process entails. Here’s an overview of each. 


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. 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.
Bankruptcy ProsBankruptcy Cons
Chapter 7 bankruptcy wipes out most debts, offering a fresh start.Chapter 7 bankruptcy can damage your credit for up to 10 years.
Chapter 7 and Chapter 13 bankruptcy don’t require you to pay taxes on unpaid debt.In some states, Chapter 7 bankruptcy can lead to the seizure and sale of your home.
Chapter 7 bankruptcy prevents creditors from sending you to collections.If you file Chapter 7 bankruptcy, you must wait another eight years before you are eligible to do so again.
Chapter 13 bankruptcy allows you to keep your house and car from foreclosure.Chapter 13 bankruptcy requires you to follow a court-ordered plan.
Chapter 13 bankruptcy allows you to discharge your debt after you complete the requirements.Chapter 7 and Chapter 13 bankruptcies will severely damage your credit.
It costs money to hire an attorney to file bankruptcy.

Debt Settlement

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 end up paying less than the total amount that you owe.
Debt Settlement ProsDebt Settlement Cons
Free credit counseling resources exist to allow you to do it yourself.Some creditors may be unwilling to negotiate.
You may be able to pay off only part of your debt and have the rest forgiven.Your account can go into collections when you stop paying.
Debt settlement companies may be able to negotiate on your behalf.You can incur late fees and penalties if you stop payment.
Debt settlement companies can charge large fees.
Not paying your bills will further damage your credit.
The amount of debt forgiven is considered taxable income.

Bankruptcy Pros

If you’re debating between the two, there are bankruptcy vs. debt settlement pros and cons to consider. Here are several of the advantages of filing for bankruptcy.

Debt Collector Relief

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

Court-Appointed Representative

When you file for bankruptcy, a bankruptcy trustee who is an officer of the Department of Justice is appointed. This person represents your estate in the bankruptcy proceeding. Having a representative can offer some reassurance, as you’ll have someone guiding you through the process.

Keep Some Assets

When you file for bankruptcy, your assets will be protected from your creditors to some degree, depending on the laws of the state you’re in. For example, your state may have a $5,000 motor vehicle exemption; if your car is below that value, you may be able to keep it in Chapter 7 bankruptcy. Chapter 13 bankruptcy allows you to keep all of your property, though you must adhere to the repayment plan.

Back Taxes

When you have debt forgiven, you’ll owe income taxes on that amount. But with bankruptcy, you won’t owe any taxes on debts that are discharged or reduced. Keep in mind, however, that income taxes you owed previously cannot be discharged in bankruptcy.

Bankruptcy Cons

There are several important disadvantages to filing for bankruptcy.


When you file for bankruptcy, you'll need to hire an attorney and pay some amount in court costs and fees. These costs can add up and may be hard to manage if you’re already in dire straits financially. 

Federal Student Loans Can’t Be Discharged

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 U.S. Department of Justice.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.

Joint Accounts Are Included

Under Chapter 7 bankruptcy, you must list joint checking accounts as assets. This is the case even if the money in the account technically belongs to the other account holder.

Criminal Charges Could Apply In Instance of Fraud

If you commit bankruptcy fraud, you can be subject to up to five years in prison. Other options include probation or fines. Bankruptcy fraud could constitute a number of actions, including failing to list an asset on the appropriate bankruptcy schedule or making a false statement in bankruptcy paperwork.

Debt Settlement Pros

Debt settlement offers several advantages over declaring bankruptcy. If you’re weighing Chapter 13 or Chapter 7 bankruptcy vs. debt settlement, here’s what to know.

Avoid Bankruptcy

With debt settlement, you don’t declare bankruptcy, so you won’t incur legal fees or have to appear in court. Additionally, because it isn’t a public process like bankruptcy, it’s not something that will come up in background checks or job interviews.

Pay Only a Portion of What You Owe

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

Option to Do It Yourself

While bankruptcy requires involving the courts, it is possible to DIY debt settlement if you stay on top of everything and are persistent. By settling your debt yourself — and avoiding bankruptcy — you could save a lot of money in fees.

Debt Settlement Cons

There are several downsides to debt settlement to consider as well when weighing debt settlement vs bankruptcy.

No Obligation To Reach a Settlement

Your creditors have no obligation to reach a settlement — even if you’re paying costly fees for their services. Additionally, some creditors refuse to work with debt settlement companies. With bankruptcy, your creditors must help you find a resolution.

Credit Score Damage

Stopping your payments is often the first step in debt settlement, which will severely hurt your credit score. Being delinquent on your accounts could also lead you to rack up late fees, which can balloon the amount you owe, and you could face collections calls.

Forgiven Debt Is Considered Taxable Income

If you do manage to reduce the amount of debt you end up paying, you’ll have to pay income taxes on the difference. This is because the amount of forgiven debt is considered taxable income.

Chapter 7 Bankruptcy vs. Debt Settlement

With Chapter 7 bankruptcy, you will have most of your debts discharged and can start over. But with debt settlement, the best you can hope for is to pay off just a part of your debts. Additionally, the amount that’s forgiven is considered taxable income, so you’ll 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 like Chapter 7 bankruptcy will. You could also face seizure of your home and other property under Chapter 7 bankruptcy.

How Do You Repair Your Credit After Debt Settlement or Bankruptcy?

Once you’ve gone through either debt settlement or bankruptcy, your credit will be severely damaged. However, there are some ways to repair it over time. 

Personal Loans

You can take out a personal loan to repair your credit after debt settlement or bankruptcy. How a personal loan works is that it’s a lump sum you borrow with your personal guarantee of repayment, with approval and terms based on your creditworthiness. When you make your payments on time, it can help to rebuild your credit.You may be able to get a personal loan through private lenders, such as banks or credit unions. However, keep in mind that getting loans after bankruptcy can be very difficult, though it’s still possible. In particular, credit-builder loans are designed to help repair your credit, though these require the payment of a refundable security deposit. Before you apply for one, it’s important to understand the advantages and disadvantages of personal loans and to make sure you’re prepared to handle debt repayment responsibly.

Credit Cards

Opening new credit card accounts is another way to repair your credit after debt settlement or bankruptcy. While you won’t qualify for most credit cards, you could be approved for subprime cards or secured credit cards. Secured credit cards work just like other cards but require the payment of a refundable security deposit before your account is opened. Getting a new credit card can result in a soft or hard inquiry on your credit report. When you receive a preapproved offer, it’s a soft inquiry. However, when you submit an application for either a credit card or personal loan, it constitutes a hard inquiry, which will adversely affect your credit score temporarily. 

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. This includes the effects of debt settlement vs. bankruptcy on credit score.Once you’re back on your feet after bankruptcy or debt settlement, you may want to start thinking about repairing your credit. One way to do so is to take out a personal loan and then commit to timely repayment. If you feel that you can benefit from a personal loan, check out Lantern’s personal loan rates to see what you may qualify for.

Frequently Asked Questions

Is Chapter 7 bankruptcy or debt settlement better?
What is the difference between a debt settlement and declaring bankruptcy?
What are bankruptcy vs. debt settlement pros and cons?
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Photo credit: iStock/Andrii Yalanskyi

About the Author

Jason Steele

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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