Debt settlement and bankruptcy are solutions to the same problem what are the most direct methods to get out of debt but they each come with their own advantages and disadvantages, and choosing the right one can be tricky. If your debts are so massive that you can’t imagine repaying them, it’s time to evaluate both options as you look to restore your credit health and financial well-being. Bankruptcy can offer the fastest path out of debt, but the long-term impact on your creditworthiness is severe. A bankruptcy will stay on credit reports from s 7-10 years, which will greatly impede your ability to get a loan, receive a credit card or buy a home Bankruptcy, which is adjudicated in federal court, either wipes out your personal debt (Chapter 7) or creates a 3-5 year plan for repaying creditors (Chapter 13). Debt settlement doesn’t require a court filing and, unlike bankruptcy, can often be handled without a lawyer or financial counselling. A settlement is a deal you negotiate with creditors to pay less than the amount owed, usually with a lump-sum payment.
Debt settlement also known as debt negotiation and debt arbitration must never be confused with credit counselling and debt management programs. In debt settlement, you or your representative attempt to get creditors (usually credit card issuers) to accept a portion of the total balance as payment in full. Individuals can try negotiating for themselves if they have access to substantial amounts of cash. The cash will be used to pay a substantial portion of their account balances — somewhere in the neighborhood of 40-70 percent.
When cash is scarce, debt settlement candidates turn to outside representatives who usually take the following steps to reach a settlement:
• Put their clients on a budget
• Order them to make no more payments on their unsecured (credit card, medical, personal loan, even student loan) debt
• Order regular deposits to be placed in a dedicated, or escrow, account
• Use the accumulated money (usually gathered over a 2-4 year period) to make an offer to settle the debt.
• Pay them. Debt settlement company fees could be as much as 20%-25% of your original debt.
Key Similarities and Differences And Bankruptcy
Let’s first acknowledge the slim similarities between debt settlement and bankruptcy: Each is designed to erase or forgive certain types and certain amounts of debt. Also, at the end of each, your credit score will have absorbed a hammering. That’s pretty much it. Beyond that, the two processes are remarkably different animals.
Personal bankruptcy falls, generally, into two types: straight liquidation of assets (Chapter 7) and reorganization (Chapter 13). Both go through the court system where a judge, ultimately, decides the outcome. Both also become part of the public record. By contrast, debt settlement most often is a private negotiation between someone representing you an attorney or debt settlement company and your creditors. Debt settlement is a private transaction. Once you have qualified for bankruptcy (even if your financial straits are dire, bankruptcy is not guaranteed; more about that below), creditors must stop hounding you for money. That’s not the case with debt settlement. During the process usually between 24 and 48 months collection calls and mail demands continue, along with late and, possibly, over-limit fees continuing to accrue, with no guarantees they’ll reach successful outcomes.
Why would creditors want to settle your debts for less than you owe?
They know that you can always file for bankruptcy, which could eliminate their ability to collect anything from you. So, they are often willing to accept less than they are owed through debt settlement. If you conclude that you can’t afford even the reduced payments negotiated from debt settlement, bankruptcy could be the best option. Personal bankruptcy comes in two varieties: Chapter 13 is essentially a payment plan that takes three to five years; Chapter 7 clears your personal debts in 6-8 months, but comes with potential pitfalls. If you own a home, you will be able to keep it under Chapter 13, though you will need to make mortgage payments after you exit bankruptcy court. Chapter 7 doesn’t offer that guarantee. Depending how much equity you have in it, your home might qualify as exempt in some states, but others allow bankruptcy trustees to sell your home to raise money to repay creditors. Chapter 7 also requires you make less than your state’s median income (half salaries above the number, half below) for a family your size. Bankruptcy frees you from debt collection, but the headaches can linger for years. Debt settlement without bankruptcy can take more time but, if negotiated properly, can do far less damage to your credit. Understanding the pros and cons of debt settlement vs. bankruptcy and making the smartest choice can have a big impact on your future finances.
When to Consider Debt Settlement or Chapter 7 Bankruptcy
If your monthly debt payments, excluding mortgage or rent, exceed 20% of your income, you have a debt problem that requires action. The seriousness of the problem, and your ability and determination to overcome it, will determine whether a debt settlement plan or bankruptcy is the better option.
Here are some scenarios in which debt settlement may provide the better path out of debt:
• You’re able and willing to negotiate with creditors or debt collectors on a settlement plan that you can afford and stick to.
• Your creditors will agree to greatly reduce your debt burden in exchange for your commitment to make a lump-sum payment.
• Your income is stable enough that you can continue to pay your mortgage or rent and other essential bills in addition to the payments required under a debt settlement, while still saving some money for emergency expenses.
Here are some scenarios in which bankruptcy is the better option:
• All other options for debt relief have been exhausted or deemed insufficient, making bankruptcy protection a last resort.
• You are in danger of losing your home to foreclosure, but Chapter 13 bankruptcy can help you get caught up on your payments.
• Making debt payments would require you to dip into your emergency or retirement savings. Retirement savings such as 401(k) accounts and Individual Retirement Accounts (IRAs) are protected in bankruptcy proceedings.
• You cannot make any payments on your debt without resorting to payday loans, which charge exorbitant interest rates.
• You’ve lost your job and lack the means to make debt settlement payments.
• Any attempt to get out of debt is going to take more than five years.
It’s important to remember that these are general guidelines, and anyone in serious debt who is weighing the pros and cons of debt settlement or bankruptcy is recommended to consult with a non-profit credit counsellor.
Utah Bankruptcy and Debt Settlement on Credit
Both bankruptcy and debt settlement can reduce your creditworthiness and lower your credit, or FICO, score for years. Bankruptcy, no matter which chapter you file under, is certain to bring down your score. The better your score is to begin with, the more it will drop.
Credit Score after Bankruptcy
Your credit score will plummet, whether you’re using Chapter 7 or Chapter 13. The higher your credit score, the more it will plummet. Wherever it starts, it likely will end in the 530-560 range, which is regarded as poor credit. A Chapter 7 bankruptcy remains on your credit report for 10 years from the date of filing; a Chapter 13 stays on the report for seven years. . Bankruptcy laws regulate what happens to your money when your case is settled. Chapter 7 cases typically clear your debts, while Chapter 13 requires partial repayment. A bankruptcy judge will decide how much you need to repay based on laws in your state.
Debt Settlement Credit Score Impact
Credit scores plunge 75-100 points after a debt settlement because it’s an admission you didn’t pay your debts as agreed. The higher your credit score, the more you will drop. The fall off is not as great as it is with bankruptcy, but it’s still significant. Debt settlement will be on your credit report for seven years and definitely impact your ability to get a loan and the interest rate you pay, if you are approved. Debt settlement typically requires that you make a lump-sum payment to clear your account. It’s generally advised that you stop making monthly minimum payments until you’ve negotiated a settlement plan, as creditors will be more inclined to negotiate with you if they’re no longer receiving any payments on your debt. But stopping payment can further damage your credit score and expose you to late fees, additional interest charges, collection efforts and lawsuits. The possible advantage to settlement is that in exchange for a payment, creditors will sometimes agree to report the settlement as “paid as agreed,” which means your score won’t get hit with negative points like it would if it were reported as just “settled.” Not all creditors report information to the three credit reporting bureaus so it’s possible, though not probable, that your settlement may not get reported.
Advantages and Disadvantages of Debt Settlement
Debt settlement can be the best way out of a financial mess, but it is full of pitfalls, debt settlement may well leave you deeper in debt than you were when you started. The biggest problem is convincing a creditor, or multiple creditors, to accept less than they are owed. Creditors aren’t obligated to enter a settlement agreement, but many are willing if they believe you can’t pay and otherwise will file for bankruptcy protection. If that happens, it means they receive little or nothing. Some people hire a debt settlement firm to represent them, but others negotiate themselves. The advantage to contracting with a debt settler is saving time and avoiding the hassle of negotiating yourself. If you decide to pursue debt settlement on your own, it will be vitally important that you educate yourself on the details of the debt that you owe, develop a realistic plan on how much you can save each month based on your current financial situation, and negotiate with creditors or collectors with a sensible repayment plan that they will agree to in writing.
Advantages to Settling a Debt
• Access to free credit counselling that can help you create and negotiate a debt settlement plan
• Pay only part of what you owe to become debt free
• Use a debt settlement company to negotiate with creditors and avoid the time and expense involved in bankruptcy
Disadvantages to Debt Settlement
• There is no guarantee creditors will be willing to negotiate with you.
• Stopping payments to convince creditors that you are serious about not paying could result in your accounts going into collection and/or legal actions aimed at garnishing your wages, further damaging your credit as your debt increases.
• When you stop payments so you can save for a “lump-sum” offer, late-fee penalties and accrued interest will increase the size of your debt.
• If you settle a debt, state and federal tax collection will treat the forgiven amount as income and require you to pay taxes on it.
• Debt settlement companies often charge expensive fees, and not all creditors are willing to work with the one you select.
• Debt settlement will damage your credit score and your ability to obtain credit in the future.
Advantages and Disadvantages of Bankruptcy
Bankruptcy chapters 7 and 13 are the two avenues individuals can use to clear their debts through the courts. Chapter 7 eliminates your debts, but in some states it might require you to liquidate all you own, including your car and house, to help compensate your creditors. Chapter 13 protects your home from foreclosure but requires that you partially repay creditors over a 3-5 year period. Because it requires repayment, it is often called wage earners bankruptcy. Both chapters will cause long-lasting damage to your credit report. In addition, student loan debt, income taxes and child support payments can’t be discharged in bankruptcy, so you will still be obligated to repay them.
Advantages to Chapter 7 Bankruptcy
• Clears most debts and offers a financial fresh start
• Doesn’t require the filer to pay taxes on unpaid debts
• Prevents creditors from pursuing collections
• Can happen in 6-8 months
Disadvantages to Chapter 7 Bankruptcy
• Damages credit report for 10 years
• Some states allow seizure and sale of your home and other properties. You should review what is exempt in your state
• Requires that you wait eight years before filing again under Chapter 7
Advantages to Chapter 13 Bankruptcy
• Protects your property, including your house and car, from foreclosure and repossession to cover debts
• After you complete required payments, you receive a discharge of debt
• You aren’t required to pay taxes on forgiven debt
• Waiting period before you can file again is two years – six years less than under Chapter 7
Disadvantages to Chapter 13 Bankruptcy
• Requires that you follow a court-ordered payment plan that lasts 3-5 years
• Reduces your credit score for years, making it difficult to borrow money or obtain credit
Free Initial Consultation with Lawyer
It’s not a matter of if, it’s a matter of when. Legal problems come to everyone. Whether it’s your son who gets in a car wreck, your uncle who loses his job and needs to file for bankruptcy, your sister’s brother who’s getting divorced, or a grandparent that passes away without a will -all of us have legal issues and questions that arise. So when you have a law question, call Ascent Law for your free consultation (801) 676-5506. We want to help you!
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— Tim Cella (@TimCella2) November 9, 2022