Debt Settlement vs. Bankruptcy

Weighing the pros and cons to find the right solution

A borrower looks over his balances.

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Debt settlement and bankruptcy are solutions for those dealing with more debt than they can realistically pay off, but both come with a cost. 

Debt settlement is when you or a third party negotiates with creditors and lenders to pay less than what you owe. Bankruptcy is a legal process in which you petition a bankruptcy court to discard your debt or create a manageable payment plan.

While both methods are in the “last resort” category, for some consumers, these kinds of solutions can help them find relief so they can work on repairing their finances. Before you choose one or the other, learn what debt settlement and bankruptcy can do for you, what they cost, and the impact they have on your short- and long-term credit health.

Key Takeaways

  • Debt settlement and bankruptcy are options of last resort for eliminating debt.
  • Using a debt settlement company could be a good fit if you can’t afford a bankruptcy lawyer and want to avoid the possibility of losing your assets to pay your debt.
  • Bankruptcy may be a better choice if you can afford the cost and want to avoid paying taxes on your discharged debt.
  • Chapter 7 bankruptcies can stay on your credit report for 10 years.

What Is Debt Settlement? 

Debt settlement refers to an agreement between a borrower and a creditor to reduce the amount of debt owed. The settlements are for unsecured debt like credit cards or personal loans, and usually, the negotiating is done by a third-party debt-settlement company.

While paying less than you owe sounds great in theory, before debt settlement companies negotiate your balances they usually recommend that you stop paying your bills for a number of months to improve your chances of settling. During this time, you save up money for a lump-sum payment, all while late fees and interest pile up and your credit takes a major hit. 

Once some time has passed, the debt settlement company will get in touch and negotiate a reduced payment. The premise is that getting paid something is better than nothing; hence, some creditors will settle. 

Debt settlement may not always go in your favor. Some creditors refuse to do debt settlements and may decide to sue you if you stop paying. Also, there are shady operators in the debt settlement space, so be very careful that you don’t choose one that can make your financial situation worse. Stay away from firms charging an upfront fee—it’s illegal for debt settlement companies to do this. 

If a creditor agrees to a settlement, the debt settlement company pays your reduced balance from the account you’ve been putting money into. The company can only charge a fee after the debt is settled. 

While you can hire a debt settlement company to negotiate on your behalf, you can also attempt to work out a debt settlement agreement on your own by contacting your creditors. Even better, if you get in touch with creditors before you fall behind, you may qualify for a hardship program that can help you better manage your payments.

Pros and Cons of Debt Settlement

  • Reputable debt settlement companies may work out decent deals

  • You can avoid the legal process of bankruptcy

  • Debt settlement is slightly less damaging to your credit than bankruptcy

  • Debt settlement isn’t a quick fix

  • You may have to be delinquent before settling

  • Debt settlement companies charge fees for something you could do on your own

  • The amount of forgiven debt is considered taxable income

  • You could be sued for delinquent payments

Pros Explained

  • Reputable debt settlement companies may work out decent deals: If you choose a good company that has industry relationships, that may help you get a strong settlement offer.
  • You can avoid the legal process of bankruptcy: Because a debt settlement is a private negotiation (unlike bankruptcy, which is public record), it’s not something that will come up in job interviews or other situations where your background might be checked. 
  • Debt settlement is slightly less damaging to your credit than bankruptcy: Though debt settlement can cause your credit score to take a massive hit during the months that you stop paying your bills, once your debt is settled, it will remain on your credit report for seven years—shorter than the 10 years for Chapter 7 bankruptcy.

Cons Explained

  • Debt settlement isn’t a quick fix: Saving up enough for your lump-sum payments to creditors can take a few years, so this isn’t always a fast path to becoming debt-free.
  • You may have to be delinquent before settling: Instead of making your payments, debt settlement companies have you put money into savings that can be used for a payment later on. In the meantime, your accounts will be hit with late payment fees, your credit score will plummet as the length of your delinquency increases, and you could be hounded with stressful collection calls.
  • Debt settlement companies charge fees for something you could do on your own: On top of the amount you’ll still owe your creditors, the debt settlement company will take a fee, thus reducing the amount that you’ll actually save. 
  • The amount of forgiven debt is considered taxable income: Yes, you’ll have to pay taxes on the amount you saved from the debt reduction. If you owed $10,000 and your creditor reduced the bill to $6,000, you’ll have to pay income taxes on $4,000.
  • You could be sued for delinquent payments: Your creditors could sue you if you for your debts before a settlement is reached, or if you stop making payments as part of your debt settlement program.

What Is Bankruptcy?

Bankruptcy is when someone claims they can’t afford to pay their debt obligations and asks a bankruptcy court to discharge what they owe. There are two main types of personal bankruptcy: Chapter 7 and Chapter 13.

Chapter 7

When people think of bankruptcy wiping out their existing debts, they are usually thinking about Chapter 7. The catch is that not everyone can qualify for this type because it is dependent on your income levels. Also, you usually have to liquidate most of your assets, though which ones you have to let go varies depending on your state. That’s why Chapter 7 is also referred to as “liquidation” bankruptcy.

Bankruptcy courts allow Chapter 7 filings if your income is below the state median income. If your income is higher than that, the court will apply a “means test” that analyzes your income and expenses for the past five years.

Chapter 13

If you can’t qualify for Chapter 7 because you make too much money, you can look into Chapter 13, which involves setting up a debt payoff plan that lasts three to five years. So, yes, you’ll still have to pay your debts, but as long as you stick to the plan, your creditors can’t bother you. The main benefit of this type of “reorganization” bankruptcy, or “wage earner’s plan,” is that your personal property is protected.

Pros and Cons of Bankruptcy

  • You can (almost) wipe your debt clean

  • Collection agencies will stop hounding you

  • You don’t have to pay taxes on discharged debt

  • Attorney fees can be expensive

  • Long-term negative impact on credit scores and credit report

  • Not all debt can be dishcarged

  • Bankruptcies are public record

Pros Explained

  • You can (almost) wipe your debt clean: With Chapter 7, most unsecured debts, including credit cards and medical bills, are fully discharged, giving you a financial reset. You can even discharge balances owed on secured debt like home and auto loans, though that requires giving up the asset.
  • Collection agencies will stop hounding you: For both types of bankruptcy, nearly all collection calls will stop.
  • You don’t have to pay taxes on discharged debt: Debt that is canceled or reduced through bankruptcy is not considered taxable income.

Cons Explained

  • Attorneys fees can be expensive: In addition to a few hundred dollars to file your bankruptcy claim, you’ll have to pay for an attorney, which could cost thousands of dollars.
  • Long-term negative impact on credit scores and credit report: Bankruptcies remain on your credit report for up to 10 years, and the immediate hit that your score will take will be drastic. Once your debt is discharged, however, your score can begin to improve again (assuming all other payment behaviors remain positive).
  • Not all debt can be discharged: You’re still on the hook for student loans, alimony, child support, and most back taxes when you file bankruptcy. 
  • Bankruptcies are public record: The stain on your financial reputation—and the fact that anyone can find out about it—is a considerable drawback that could affect future job prospects or housing rentals.

Debt Settlement vs. Bankruptcy

Neither debt settlement nor bankruptcy should be your first approach to dealing with debt. Assuming you’ve exhausted all other options (such as credit counseling, debt management plans, debt consolidation, etc.), debt settlement or bankruptcy could offer a way out. 

If you’ve managed to keep your accounts in good standing thus far, understand that stopping payments to start the process of debt settlement is going to do real harm to your credit reputation, and you could be bombarded with collection calls or even lawsuits. On the other hand, filing for bankruptcy removes the pressure of debt collectors, but it will become a part of your public record and remain on your credit report for up to 10 years.

That said, bankruptcy is best for those who have a very large amount of debt, and for whom there is no end in sight for reducing that debt. Though bankruptcy has consequences from a credit perspective and you’ll have to pay lawyer fees, it shuts down debt collectors and forgiven debt is not taxable. Then, once your balances are discharged (or you complete a payment plan if it’s a Chapter 13 bankruptcy), you can start back on the road to recovery. 

For those with the means to set aside some funds, or who don’t have enough debt to warrant a bankruptcy filing, negotiating down what you owe through debt settlement could end up being the more favorable option. You could try to do this on your own, but the risky part is that there are no guarantees that your creditors will agree to work with you. 

And while choosing to work with a debt settlement company is also a gamble, reputable ones that have working relationships with creditors should be willing to give you an honest assessment upfront of what it will cost, how long the process will take, and how much money you could save.

The Bottom Line

Debt settlement and bankruptcy are the two least desirable routes toward financial recovery for those overwhelmed with unsecured debt. But if you’re in deep enough, one of these solutions could help you get your finances back in order.

Deciding which strategy is best for you really depends on your unique financial situation. Consider speaking with a credit counselor who can help you understand your options. Then, if you decide to move forward with a debt settlement company or bankruptcy attorney, be sure the agency or attorney has a strong reputation and takes the time to answer all of your questions up-front.