What's the Difference Between Debt Settlement and Bankruptcy?
Dealing with problem debt is extremely stressful, especially if your repayments exceed your disposable income. If this sounds familiar, it could be worth considering debt settlement or filing for bankruptcy.
Debt settlement involves coming to an arrangement with your creditors to reduce how much you owe, while bankruptcy is a court-supervised process that writes off certain debts. Below, we'll explore both to help you decide which option is right for you.
Filing bankruptcy is a method of freeing yourself from the obligation of paying off unsecured debts, such as credit cards and medical bills. The rules for declaring bankruptcy follow the U.S. Bankruptcy Code, which has several chapters. Individuals file for Chapter 7 or Chapter 13 bankruptcy, while businesses file for Chapter 11 bankruptcy.
You must file a Chapter 7 bankruptcy with the federal court, and you must also meet specific criteria to be eligible. People filing for bankruptcy must first undergo credit counseling and demonstrate that they have insufficient disposable income to pay off their debts. Furthermore, your unsecured debts can't exceed $419,275, while your secured debts can't exceed $1,257,850. You can't file for bankruptcy more often than once every eight years.
If the court approves your application, it will discharge all eligible debts. Therefore, you'll no longer have to repay those debts, although you'll have to liquidate any nonexempt assets to repay as much as possible to your creditors. Examples of nonexempt assets include second homes, investment assets, and valuable personal possessions. On the other hand, you may not have to repay anything if you don't own valuable assets.
A Chapter 13 bankruptcy, also known as a wage earner's bankruptcy, could be a better option if you have a regular income. Chapter 13 bankruptcy allows you between 3 and 5 years to settle your debts using disposable income. A court-appointed trustee oversees the process to ensure you keep up-to-date with your repayments. The advantage of this type of bankruptcy is that it often protects your home and gives you extra time to resolve problem debt.
While declaring bankruptcy is the right option for some people, there are significant downsides. Bankruptcy can cause damage to your credit rating, and it remains on your file for 10 years, so you may find it challenging to secure credit in the future. Furthermore, you can't use it to discharge certain types of debt. Examples of debts ineligible for bankruptcy discharge include:
- Unpaid child support or alimony
- Personal injury debts
- Student loans
- Unpaid taxes
Debt settlement, also known as debt relief or debt adjustment, involves coming to an agreement with your creditors to make your debt more manageable. You can talk to your creditors directly or pay a third-party company or attorney to do so on your behalf.
How a debt settlement plan works depends on your circumstances and what your creditors agree to. For example, your creditors may reduce the amount you owe or put you on a lower interest rate to reduce your monthly payments. Once you've settled, it's essential to stick to your agreed repayment plan.
Sometimes, debt settlement companies advise their clients to stop making repayments on their debts and put money into an escrow account while sticking to a tight personal budget. During this time, your creditors will continue pursuing you for repayment. Once you've saved a significant amount of money in the escrow account, the settlement company will approach your creditors and offer a lump sum payment in return for writing off the debt. This method is risky because your creditors may refuse the offer. It could also increase your debt by incurring penalties and fees, and you may end up filing for bankruptcy anyway.
Debt settlement can impact your credit score, and any late or missed payments remain on your file for seven years. You should also keep in mind that forgiven debts are taxable and account for taxation when planning your finances.
Debt settlement and bankruptcy both reduce how much you owe on your debts, and either option is bad for your credit rating. However, bankruptcy is a legal process overseen by the courts and becomes a public record, while debt settlement is usually a private process between you and your creditors.
Once the court approves your bankruptcy, creditors included in the bankruptcy settlement can't legally continue to pursue you for payments. Debt settlement can take considerably longer, and it often takes years to pay off your debts on a debt settlement plan.
It's essential to consider your finances and personal circumstances when weighing up debt settlement versus bankruptcy. Debt settlement could be the most suitable option if you can't manage your repayments but don't qualify for bankruptcy. It could also be preferable to bankruptcy if you don't want your financial difficulties to become public. However, debt settlement is often stressful, as you'll typically receive frequent requests for repayment.
Bankruptcy could be the best option if you meet the bankruptcy eligibility criteria and own no (or few) nonexempt assets. Generally, bankruptcy works best if you have large amounts of unsecured debt that you have no reasonable hope of paying off.
Debt settlement and bankruptcy are both last-resort options for dealing with problem debt, as they have significant implications. Therefore, it could be worth considering other debt management methods to see if there's a less damaging way to handle your debts.
For example, a debt consolidation loan could be better if you can afford the repayments and secure a decent interest rate. Speaking to a debt counselor or debt support charity can help you decide if this option could be right for you.
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