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Bankruptcy vs Debt Settlement: Which Is Right For You?

You’ve done your best to keep up with your debt payments but find yourself falling further and further behind. Debt collectors are calling about unpaid bills and some are even threatening to sue. So what do you do?

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Filing bankruptcy can wipe the slate clean and get your creditors off your back but it comes at the expense of your credit. Settling your debts is one alternative but it does have some drawbacks. If you’re on the fence about which road to take, the following guide breaks down the basics.

Filing Chapter 7 Bankruptcy

You have two options when it comes to a bankruptcy filing and they both work differently. In a Chapter 7 bankruptcy, your debt is wiped out, regardless of how much you owe. The kinds of debts you can get rid of through Chapter 7 include medical bills, credit card bills and unsecured loans. Student loans generally can’t be discharged in either type of bankruptcy unless you’ve got a sustained financial hardship that keeps you from making your payments.

To file Chapter 7, you have to meet certain income guidelines under the means test. The guidelines are determined using Census Bureau data. They’re based on where you live and how many people are in your family. You have to be at or below the income limit established for your family size to qualify for Chapter 7, unless you can prove that you don’t have enough disposable income to pay a certain percentage of your debt each month.

One disadvantage of Chapter 7 is that you may have to give up some of your assets as a trade-off for eliminating your debt. These assets are turned over to the bankruptcy trustee overseeing your case, who’s responsible for liquidating them and using the proceeds to pay your creditors. Depending on where you live, you can claim federal or state exemptions to protect certain assets, like bank accounts, jewelry or vehicles. But there are limits to how much you can exempt.

How Chapter 13 Works

Chapter 13 is also a way to clear your outstanding debts but the process is a little more involved. Typically, a Chapter 7 bankruptcy can be completed within six to nine months, but it can take up to five years to get a discharge in a Chapter 13 case. Unlike Chapter 7, there are limits to how much debt you can include in a Chapter 13 filing.

When you file, you have to agree to pay back some or all of your debts. The amount you have to pay back typically depends on the types of debt included in the bankruptcy and how much you owe. A Chapter 13 payment plan can last three or five years, based on your income. If you default on your payment plan, the case can be dismissed which leaves you open to collection actions and you won’t get back any of the money you paid in.

The upside of a Chapter 13 case compared to Chapter 7 is that you get to keep all of your assets. If you’re behind on your mortgage payments, you can also file Chapter 13 to get caught up if a foreclosure is pending. Depending on whether you’re upside down on your home, you could also use a Chapter 13 filing to get rid of a second mortgage.

Debt Settlement Basics

Settling a debt means asking your creditor to accept less than what’s owed to resolve the account. Generally, creditors will only settle a debt once your account falls significantly past due. The amount that you can settle a debt for depends on the creditor, but you may be able to settle for anywhere from 35 to 75 percent of the total balance.

There are companies that offer debt settlement services for a fee but it’s possible to settle a debt on your own. Once you decide how much you can afford to pay, you just call the creditor up to get the negotiations started. Typically, you have to be able to make one lump sum payment or several smaller payments if your offer is accepted, so you should only consider settlement if you have cash on-hand.

If the creditor is willing to work with you, they may try to make a counteroffer but you should only agree to what you can afford. Once an offer is accepted, you pay the creditor and the remaining balance is forgiven. The account will be reported as “Paid” or “Settled” on your credit and you won’t have to worry about any additional collection actions.

Debt settlement has advantages and disadvantages compared to bankruptcy. It allows you to get out of debt faster and it’s less damaging to your credit. In terms of the downsides, you may have to report canceled debt on your taxes, depending on how much is forgiven. If you can’t get all of your creditors to agree to a settlement, you may still end up having to file bankruptcy if one of them decides to sue.

The Bottom Line

Bankruptcy and debt settlement are just two options to consider when you’re trying to deal with the debt monster. If you’re strapped financially because of a job loss or unexpected illness, bankruptcy may be the only light at the end of the tunnel. Debt settlement, on the other hand, may be the better choice if you want to minimize the impact on your credit. Weighing the pros and cons of each option carefully can help you find the best fit for your situation.

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Photo Credit: RobertDentonAttorney

Rebecca Lake Rebecca Lake has been writing about the nuts and bolts of personal finance for nearly a decade. She is an expert in investing, retirement and home buying topics. Her work has been featured on The Huffington Post, Business Insider, CBS News, U.S. News & World Report and Investopedia. As a homeschooling mom of two, she's always looking for ways to make the most of every dollar.
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