Debt Relief Vs. Bankruptcy: A Guide

Whether it be due to a job loss, a divorce, medical bills after an accident or something else, it’s possible to fall into debt any number of ways. A debt relief program can help you restructure or reduce the amount you owe if you’re struggling to keep up with your payments. However, bankruptcy might be the best solution for you if you’re deep in debt with no way out. So, how do you know which strategy is best?

Debt relief and bankruptcy can both help you tackle debt and get back on the path to healthy finances. Let’s take a closer look at the differences between debt relief and bankruptcy so you can decide which option can best help you get a fresh start.

At A Glance: Debt Relief Vs. Bankruptcy

Debt relief and bankruptcy are both methods you can use to tackle overwhelming debt.

• Bankruptcy: When you file for bankruptcy, you petition a court to absolve you of some or all of your debt. You may need to sell your possessions or follow a repayment plan before a court discharges your debt. Bankruptcy can’t clear every type of debt but is useful for clearing away unsecured debt. Your credit score will drop significantly after bankruptcy.
• Debt relief: “Debt relief” is an umbrella term that covers multiple methods of addressing debt. Credit counseling, debt consolidation and debt settlement are all examples of debt relief. Your credit score may decrease after debt relief, depending on the method you choose.

Before making a decision, learn more about the finer points of each option so you can choose the best strategy for handling your debt. 

Is Debt Relief Better Than Bankruptcy?

Whether debt relief or bankruptcy is better depends on a variety of factors. But before we get into all that, let’s deal with just bankruptcy. A legal process that can help relieve you of certain types of debt, bankruptcy requires hiring a bankruptcy lawyer before you actually file for bankruptcy. The goal of most bankruptcies is to wipe away debt and give yourself a fresh financial start.

Declaring bankruptcy can be a very effective way to eliminate debt, but it isn’t a complete solution. That’s because bankruptcy can’t discharge all forms of debt. For example, owed child support payments and most student loans are exempt from bankruptcy.

Understanding The Types Of Bankruptcy

The two main types of bankruptcy classifications are:

• Chapter 7, or liquidation bankruptcy: A court may order you to liquidate some of your property. Property essential to everyday life (like your clothing and furniture) is exempt from liquidation in most states. Once you sell off your eligible assets and return the money from the sale to your creditors, the court relieves you of your remaining debt. Chapter 7 bankruptcies have a larger impact on your credit than Chapter 13 bankruptcies.
• Chapter 13, or reorganization bankruptcy: A court looks at your finances and orders you to complete a payment plan to your lenders. Most payment plans last 3 – 5 years, after which a court wipes away your remaining debts. Chapter 13 bankruptcies are typically more expensive than Chapter 7 bankruptcies. However, they allow you to keep your property and have less of an effect on your credit score.

No matter which type of bankruptcy you choose, you’ll see a significant impact on your credit score. It can take years to recover from the effects of a bankruptcy. When you have a bankruptcy on your credit report, you’ll have a much harder time opening new cards and loans.

Pros And Cons Of Chapter 7 And Chapter 13 Bankruptcies

Here are some common advantages and disadvantages of Chapter 7 and 13 bankruptcies. Seek a bankruptcy law attorney’s legal advice so you can choose the best option for your financial situation.

Pros

Cons

Diving Into Debt Settlement Programs

Unlike bankruptcy, most types of debt relief don’t involve a court or legal proceedings. Instead, you negotiate with your creditors and create a plan to repay all or a portion of your debt. Popular debt settlement plans include:

• Credit counseling: Do you have a large amount of debt but aren’t sure where to begin repayment? You might want to call a credit counseling agency, which will look at your income and debt and recommend a solution. The agency may also help you enroll in other debt relief programs.
• Debt consolidation: Debt consolidation takes debt from multiple sources and combines it into one loan. Many homeowners consolidate their debt with a cash-out refinance because mortgage interest rates are typically lower than various other types of interest rates. You can also use a personal loan to consolidate debt. A debt consolidation loan doesn’t reduce what you owe, but it can make payments more manageable.
• Debt management plan: When you accept a debt management plan, you make a monthly payment to a credit counseling agency. Your agency then distributes a percentage of your payment to all your creditors, closing accounts as you pay them off. Credit counseling agencies also often negotiate lower interest rates with your creditors to save you money.
• Debt settlement or negotiation: Debt settlement or debt negotiation plans allow you to pay less than you owe on your current accounts. A credit counselor can negotiate with your creditors to reduce your outstanding balance if they think you might file for bankruptcy.

Each type of debt relief has benefits and drawbacks. However, debt settlement plans have a major advantage: Unlike bankruptcy, they’re not court proceedings. That means you won’t have the added expense of a law firm, nor a public record of your financial situation.

 We’ll take a closer look later on at how debt relief methods affect your credit score.

Bankruptcy Should Be A Last Resort For Extreme Debt

So, is debt relief better than bankruptcy if budgeting your way out of debt doesn’t work? The answer depends on your situation. If you have enough money coming in to cover a percentage of your debts, debt relief is usually the better solution. Relief programs are easier and more cost-effective than filing for bankruptcy, because you don’t need a bankruptcy attorney to use them.

If you’re deep in debt or owe money to multiple creditors, bankruptcy might be the only reasonable solution. You should always view bankruptcy as a last resort. Also, consider the challenges of fixing your credit after bankruptcy.

How Does Debt Relief Work And What’s The Impact On Your Credit?

The effect of debt relief that you’ll see on your credit report depends on the type of debt relief program you choose.

A call to a credit counseling agency won’t affect your score, but the company might enroll you in another type of relief plan that does. Debt consolidation also usually has a minimal effect on your credit score as long as you make your payments on schedule.

Expect A Debt Settlement Plan To Lower Your Credit Score

A debt management plan will usually lower your credit score. When you accept a debt management plan, you typically agree to allow debt settlement companies to close credit cards as you pay them off.

Closing a card lowers your credit score because it reduces your overall line of available credit. However, this will have only a minor long-term effect on your credit score. You can repair your credit by opening a secured credit card after completing your management plan.

If you accept a debt settlement, you may see an effect on your credit. If you’re able to make a lump-sum payment, not all lenders will report a credit settlement to your credit reporting bureau.

But, many lenders will accept your payment and then report that you settled your debt. This will usually appear on your credit report as “settled” or “paid less than full balance.” These items hurt your credit score.

Creditors May Only Settle A Debt If You’re Already Behind On Payments

Debt settlement might also damage your credit score indirectly. Most creditors won’t agree to settle a debt with you if you aren’t already behind on payments. Creditors usually need to believe you’re at a serious risk of bankruptcy before they’ll agree to settle your debt.

You usually need to fall behind on your payments by at least 180 days before you have a chance of settling your debt. This equals 6 months of missed payments – each of which will negatively impact your credit score.

What Is The Difference Between A Debt Relief Program And Debt Settlement?

Debt settlement is a type of debt relief that absolves you of a portion of your debt. When you take a debt settlement, you agree to give your creditor a lump-sum payment covering some of your debts. In exchange, your lender agrees to forgive your remaining balance.

Why would a credit card or loan company agree to accept a lower balance than you owe? Creditors know that if you file for bankruptcy, they won’t get any of their money back. Unsecured debt (like credit card debt) is easily wiped away during bankruptcy. This leaves the debtor with nothing.

If your creditors believe you’re very likely to file for bankruptcy, they might be willing to settle your debt. However, creditors have no obligation to accept your settlement plan or forgive any amount of your debt.

Debt Relief Includes Debt Settlement And Bankruptcy

To be totally clear: The term “debt relief” is a catchall phrase referring to any program or method you use to alleviate your debt. In fact, debt settlement – and bankruptcy – are both types of debt relief, but debt relief doesn’t refer to any specific method of controlling your debt.

Can You File Bankruptcy If You’re In A Debt Relief Program?

You can file for bankruptcy while you’re pursuing other forms of debt relief. If you lose your income or you’re forced to take on even more debt, you might have no choice but to file. However, this isn’t usually recommended, especially if you’ve already started paying toward your debt. After you complete the bankruptcy process, you won’t get back any of the money you paid your creditors.

You’ll also still need to complete the required bankruptcy steps even if you’re already enrolled in a repayment program. This can include liquidating your assets and changing your repayment schedule. Any court order you receive will override or cancel agreements you made with your creditors. If you take a form of debt relief that harms your credit, a bankruptcy can compound these effects and lower your score even more.

Carefully consider all your debt relief options before choosing a course of action. There’s no point in signing up for a debt relief program if you have no way to cover the repayments. Take a hard look at your finances, know exactly how much you owe and explore each of your options before moving forward.

FAQs: Debt Consolidation Vs. Bankruptcy

These are questions people often ask about whether a debt settlement program is a better option than bankruptcy for helping them become debt-free.

What hurts credit more – debt relief or bankruptcy?

It depends on your financial situation. If your credit score has fallen below 600, a Chapter 7 bankruptcy can actually improve your credit score in time. However, a bankruptcy will typically harm your credit more than debt relief because it stays on your credit report longer.

Is it better to claim bankruptcy or settle debt?

Settling your debt can prevent your financial difficulties from becoming a matter of public record. It can also protect anyone who’s agreed to be a co-signer for you. Settling your debt can also help you keep more of your assets.

What debts can’t be forgiven in bankruptcy?

Typically, child support payments, alimony and student debts are exempt from bankruptcy.

How long does debt relief stay on my credit report?

A debt settlement will remain on your credit report for 7 years past the original delinquency date. Still, that’s less than the 10 years a Chapter 7 bankruptcy will stay on a debtor’s credit report.

The Bottom Line: Understand Debt Settlement Vs. Bankruptcy To Make The Right Decision

In many cases, it’s best to choose debt relief options other than bankruptcy. A debt settlement or consolidation program, for example, can help you avoid liquidating your assets. Bankruptcy is a viable option in some extreme cases, though. 

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