Managing your debt plays a critical role in achieving financial success. Knowing what to do when debt levels becomes overwhelming can save you both time and money. The following is presented for informational purposes only and is not intended as legal advice.
Settling debts or declaring bankruptcy are two routes that some people choose to get out from overwhelming debt. Each offers its pros (and cons). But the goal is the same — get back on your financial feet.
How Does Debt Settlement Work?
If you’re already behind on your bills, you may be able to settle your debts with your creditors.
“In a debt settlement situation, the goal is to pay the creditor less than the entire amount and pay them over time interest-free,” says Leslie H. Tayne, Esq., a financial attorney and author of Life and Debt. “The debt settlement company or attorney is negotiating with them to settle the debt.” Alternatively, you may be able to negotiate your own settlements with your creditors.
A creditor may agree to take less than the full amount you owe because at least it’s getting something — particularly if you have an unsecured loan (such as credit card debt) and don’t owe so much that it’s worth the creditor’s time and money to sue you.
Generally, you’ll have to put money aside each month and build up a fund that you can use to settle your debts. You (or the company representing you) will then offer the creditor a lump-sum payment or a monthly payment plan that results in repaying less than what you currently owe.
How Does Chapter 13 Bankruptcy Work?
There are two common types of consumer bankruptcy, Chapter 7 and Chapter 13.
A Chapter 7 bankruptcy (i.e., liquidation) could immediately wipe out your debts. However, you’ll need to qualify based on your income, and you’ll be forced to sell your non-exempt property.
A Chapter 13 bankruptcy may be a better option (and potentially your only option) depending on your income. With a Chapter 13 bankruptcy, you can:
Keep all your property
Catch up on payments and avoid foreclosure or repossessions
Make monthly payments for three to five years and then have your remaining debt discharged
There are still limitations on who can file a Chapter 13 bankruptcy, though. “You don’t get the right to file bankruptcy, you have to qualify for a Chapter 13, which means your income has to meet the means tests,” says Tayne. “ Then, you have to provide a proposed plan on how you’re going to pay back your creditors.”
When Might Debt Settlement Be Best?
If you’re already behind on your bills (creditors are unlikely to accept less than the full amount owed if you’re current) and primarily have unsecured debts, then debt settlement might be a good option.
You could benefit by repaying less money and may be able to set up a monthly payment plan for the settled amount. Tayne also points out that when you apply for insurance or financial accounts in the future, “they may ask if you’ve filed bankruptcy. But they generally won’t ask if you’ve settled debts.”
Debt settlement can also be more flexible if your financial situation changes. “In a bankruptcy situation, you have to report the changes back to the trustee, and that could alter your plan,” Tayne says. But with a debt settlement, you can stick to the same plan even if your income increases.
The drawbacks to debt settlement include potentially more severe consequences for a missed payment. “If you miss a payment, the creditor may be able to get the full amount you owed minus the amount you already paid,” says Shawn M. Yesner, Esq., owner of Yesner Law, PL. Missing a Chapter 13 bankruptcy plan payment could lead to your case being dismissed, but you may have a chance to catch up on your payments first.
Additionally, even if you can settle some of your debts, other creditors might not agree to your debt settlement offers, which could leave you on the line for the full amount.
You’ll also need to watch out for debt settlement scams. You may be left with larger balances as your debts accrue interest and fees during the settlement “process,” if the company isn’t able (or, even worse, never tries) to settle the debts.
When Might Chapter 13 Be Best?
“The issue that I find when I’m doing a debt settlement is the borrower must have a lump sum of money to get rid of the creditor, or has to be able to afford a monthly plan,” says Yesner. “The debt settlement plan only works if you can settle with all of them. Otherwise, you may wind up in bankruptcy anyway.”
Additionally, settling with a few creditors can lead to issues if you wind up declaring bankruptcy later. “You’re not allowed to give preference to one creditor before filing bankruptcy,” says Yesner. If you’ve already settled debts, the bankruptcy trustee may raise your monthly payments and use the money to offset the earlier settlements. Or, it could clawback your settlement payments and spread out the money amongst your creditors.
“A lot of times, the Chapter 13 will be a more efficient use of your money,” says Yesner. This is because your Chapter 13 monthly payment amount may be lower than the combined monthly payments from debt settlements, and the remainder of your debt could be discharged after you complete the bankruptcy payment plan.
Chapter 13 may also be a better option if you’re dealing with a foreclosure or vehicle repossession. You may lose your home or car while pursuing a settlement, but could be given the opportunity to catch up with a Chapter 13.
However, Chapter 13 can result in repaying more overall than debt settlement. You also won’t be able to file for a Chapter 7 bankruptcy during the next six years, will be on a payment plan for three to five years, and all your disposable income will be tied up the payments.
The bankruptcy may also have a larger negative impact on your creditworthiness (although, both settlement and bankruptcy can hurt your scores) as the bankruptcy can live on your credit reports for up to seven years after you file.
A Third Option — a Debt Management Plan
Another option may be to work with a certified credit counselor to set up a debt management plan (DMP). With a DMP, you’ll make one monthly payment to the credit counseling organization, which will then distribute the money to your creditors.
Although you’ll wind up repaying the debt in full, the credit counselor will negotiate with your monthly payment by reducing your interest rate, waiving fees, or moving you to a different payment plan. If you’re primarily dealing with a lot of credit card debt, a DMP can be an affordable option with a more positive impact on your credit history than debt settlement or bankruptcy.
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