Debt Settlement vs. Bankruptcy

Debt settlement can ruin your credit and doesn't bring the fresh start of bankruptcy.
Liz Weston, CFP®
By Liz Weston, CFP® 
Edited by Des Toups

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When it comes to deciding between debt settlement and bankruptcy, it’s important to have knowledge about what’s involved in both processes.

Thanks to increased regulation and enforcement, the much smaller number of settlement companies that remain often do what they promise: persuade at least some of a borrower’s creditors to forgive part of the debt, typically in exchange for a lump sum payment.

Hiring a negotiator could be a reasonable alternative to bankruptcy for some. But debt settlement is not as consumer-friendly as the industry presents it.

Credit scores can begin to recover immediately after either process is complete. The difference, of course, is that Chapter 7 bankruptcy typically takes months, while debt settlement typically takes years. Plus, bankruptcy halts collections activity, including lawsuits, and can end wage garnishments.

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Where debt settlement falls short

Here are some of the biggest problems with debt settlement:

Negotiations can take years. Customers are told to stop paying their credit cards, loans and other debts and funnel money instead into a savings account. Freedom Debt Relief, the largest debt settlement company, says half of its customers eventually settle at least 75% of their debt before fees, but the process usually takes three to four years.

The math often doesn’t work. On average, debts are normally settled for 45% to 50% of the current balance, which is often higher than the initial balance because of late fees and interest. The typical debt settlement fee is 20% of the debt at the time of enrollment. The amount of forgiven debt is usually reported to the IRS and is usually taxable as income.

When does debt settlement make sense?

Neither debt settlement nor bankruptcy is a good option for people who can pay their bills. Those who want to lower their interest rates can refinance with a personal loan if they have decent credit or sign up with a nonprofit credit counselor’s debt management plan if they don’t.

So when might debt settlement make sense? When your debt is unmanageable and you can’t or won’t file for Chapter 7 bankruptcy. If your only bankruptcy option is a Chapter 13 payment plan, which typically requires three to five years of payments before any remaining balances are erased, settlement could resolve your debts a bit faster so you can begin to build credit again.

People should research their alternatives carefully. Only bankruptcy attorneys are required to put their clients’ interests first; other debt relief providers aren’t required to tell you if other options might work better.

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This article was written by NerdWallet and was originally published by The Associated Press.

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