Bankruptcy and Debt Settlement: Making the right choice

The condition of the economy has deteriorated over the last few years to such a point that financial pressure forced people to depend largely on credit as means of meeting expenses.  The result of heavy borrowing coupled with hardening credit conditions has led to the creation of an exceedingly large public debt load.  The components of this huge debt pool includes a variety of borrowing instruments like credit cards, pay day loans, mortgages, etc.  At the moment, a sizable portion of the population is trapped under a mountain of debt and there are only a few solutions which can effectively alleviate the situation.  The most effective options for managing out of control debts include debt settlement or bankruptcy.

Each of these options has its own unique benefits and disadvantages.  Depending on the desired outcome and a few other factors, the choice between debt settlement and bankruptcy can be easily elucidated by comparing them and defining their scope.

What is debt settlement?

The process of debt settlement is known by many names such as debt arbitration, credit settlement and debt negotiation.  The process involves the debtor or a party (usually an attorney) representing a debtor negotiating with the creditor to reduce the balance of the debt.  In case the creditor and the debtor reaches an agreement, the debtor would pay back a portion of the debt and the creditor would then consider the account to be paid in full or paid as settled.  Once the process has been completed and the account has been settled, the debtor doesn’t need to worry about the debt anymore.

The process of debt settlement is not complex or technical and a debtor can do it even without consulting an attorney.  Initiating the process would require the debtor to fall back on his monthly payments which would in turn alert the creditor of the debtor’s inability to pay.  This would drive the creditor to negotiate with the debtor so that at least a portion of the money can be recovered via a lump sum payment.  Debt settlement does damage your credit score simply because you have to fall back on your regular payments just to initiate the settlement process.  Moreover, this method of managing debts is only applicable for unsecured debts like credit card bills and payday loans.

What is bankruptcy?

Bankruptcy is defined as the legal status of an insolvent person.  In other words, a person declares bankruptcy only when he is absolutely unable to repay his creditors at any cost.  Most individuals and businesses resort to bankruptcy in order to have their debts discharged, completely or partially, under the protection of the federal bankruptcy court.  There are two different objectives that can be achieved through bankruptcy which are liquidation and reorganisation.  The latter is mostly applicable for businesses.

Most individuals prefer to file bankruptcy under either Chapter 7 or Chapter 13 detailed under the Title 11 of the United States Code.  Filing under either chapter has its own set of advantages and disadvantages.  For example, by filing for Chapter 7 bankruptcy an individual has the option of discharging his secured debts like mortgage and car loan as well as unsecured debts like credit card debts and medical bills.  Under bankruptcy law, individuals have the option of repaying their debts on easy terms and listing which debts they want to discharge.  Although bankruptcy seems to be a good option for getting out of debt, it has disadvantages.  Filing under either Chapter 7 or Chapter 13 will entirely ruin your credit score.  Moreover, it will show up on your credit report for a period of 7 and 10 years for Chapter 13 and Chapter 7 respectively.

Debt Settlement Vs. Bankruptcy

Even though both bankruptcy as well as debt settlement seems like equally viable options for managing debt, they do have subtle differences which makes one preferable over the other.  Here is a breakdown of the upside and downside of each of these methods.

• Effect on credit score – Debt settlement is a much better option if you want to keep your credit score as undamaged as possible.  Although, falling back on your payments and settling a debt will affect your credit score negatively, filing for bankruptcy on the other hand would completely devastate your credit score. 
• Effect on creditworthiness – In case you file bankruptcy under Chapter 7, the item will stay on your credit report for 10 years.  Bankruptcy doesn’t look good to a potential lender when he is in the process of reviewing your credit score.  It will affect your future chances of being approved for a mortgage or a car loan.  On the other hand, debt settlement wouldn’t have such a long lasting adverse effect on your creditworthiness.  Settled accounts appear for only 7 years and are not viewed as negatively as bankruptcy.
• Information privacy – Bankruptcy is a matter of public record and it each and every one of your creditors as well as employers and family members.  There is a substantial amount of economic and social stigma which arises from declaring bankruptcy.  Debt settlement, on the other hand, is a discreet process which keeps your privacy intact and there are almost no direct social consequences.
• Legal implications – Declaring bankruptcy would mean that collectors and creditors would cease communicating with you by order of the bankruptcy court.  As long as you are under the protection of the federal bankruptcy court, your creditors cannot file suit against you or seize your assets.  In case you choose to settle your debts, creditors and collectors have the option to sue you and in case they win the lawsuit, they can garnish your wages and put a lien on your assets.
• Tax implications – Cancelled debt or the forgiven portion of a debt is considered to be income as per the IRS.  In case you have settled a debt for anything less than the actual amount, the forgiven portion of the debt becomes taxable and you will need to fill a 1099c form and include it in your yearly tax return filing.  Through bankruptcy, all your debts are discharged and you are declared insolvent and you are therefore not liable to pay taxes on the discharged debts.

Bankruptcy and debt settlement are the most common choices for people who are struggling to manage their debt load.  Each of these methods have unique implications, both legal and financial.  Although bankruptcy protects you under federal law, it also ruins your financial history and especially your credit rating.  Debt settlement on the other hand has a few legal implications but in the long run, it is more financially sound.

This article has been contributed by Allen Smith.  He is a contributory writer for Oak View Law Group.  He is also a financial advisor and guest author for acclaimed blogs.  Allen has been writing for more than five years and helping people to get wise with their money.  His interests include attending financial seminars, writing columns related to debt settlement, non profit debt settlement, bankruptcy and visiting personal finance blogs.