If you’re having trouble paying off your debts, then you might hear about an option called “debt settlement.” Some debt settlement companies, attorneys, and even people you know may tell you it’s a much better option than bankruptcy. But what is it, exactly? And what are the key differences between filing for bankruptcy and undergoing debt settlement?
Defining Debt Settlement and Bankruptcy
As you probably know, bankruptcy means you legally admit that you cannot pay your debts. Bankruptcy is a legal process that protects you against your creditors, discharges (or gets rid of) most of your debt, and allows you to rebuild your finances essentially from scratch. Not paying your debts severely damages your credit, but filing for bankruptcy helps fix your credit.
Debt settlement is when you negotiate with your creditors to settle (or pay off) your debt in a lump sum for less than the total amount. For example, let’s say you have $25,000 in credit card debt. You may settle with the credit card company by paying a lump sum of $15,000 if you have the money. A debt settlement company or attorney negotiates with the creditor by withholding your payments until the creditor agrees to a lesser amount. Your credit ends up hurting badly just as with bankruptcy, but the damage sometimes isn’t as bad.
The Dark Side of Debt Settlement
While debt settlement may seem like a better option because you avoid bankruptcy, there are a few bad aspects to it that often surprise people who use it as a shortcut.
- You increase your threat of a lawsuit. Debt settlement is not a legal process. Instead, you’re playing at a dangerous business negotiation. When you or your debt settlement representatives threaten not to pay creditors, those creditors may sue you.
- You delay resolving your most critical debt issues. When you or your debt settlement representatives are negotiating, you put pressure on creditors by waiting them out. While you withhold payments, you are working to scrounge up enough money for the lump sum. This negotiation process can take up to two years—two years during which you’re still plagued by your debts and possible lawsuits.
- You may pay high interest on your unpaid debt. When you’re not paying your debts, interest adds up. You’ll eventually need to pay that interest, and so your total debts continue to increase as you wait.
- You will pay high fees to your debt collection representative. That’s more money added to your debts.
- You will need to pay income tax on your unpaid debt. Let’s say you settle a $25,000 debt for $15,000. That means the government will view the remaining $10,000 as income—and you will need to pay taxes on it.
- Debt settlement has an extremely low success rate. Estimates vary, but it’s safe to say that debt settlement often doesn’t work well to completely get rid of debt.
Bankruptcy: Harsh But More Effective
Sure, bankruptcy will negatively affect your credit for a long time, and it will take years to rebuild your finances. But think of bankruptcy like the surgical removal of your debt. It will hurt in the short term but it will remove your debt problems in the long term.
Unlike debt settlement, bankruptcy results in:
- No lawsuits from creditors. Bankruptcy law protects you from them.
- Quick resolution of your debt problems, usually within about three months.
- No more interest on your debt. Your unsecured debts (like credit card debts) are discharged—meaning they’re all wiped clean.
- Some limited legal fees for your attorney, filing paperwork, and court.
- No taxes owed on unpaid debt.
- 100% success rate. Bankruptcy is not a business negotiation—it’s a legal process that must be followed to the letter.
Considering either debt settlement or bankruptcy for your financial situation? Call us for a free consultation.