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Debt Settlement vs Bankruptcy: What's the Difference?

November 30, 2021

by Sydney Wess

Debt settlement vs bankruptcy is a common point of contemplation for those in tough financial situations. Both processes are intended to help people deal with their debt and move on, but companies must align their needs with the features of each option before making a choice. 

When faced with spiraling debt and no obvious way out of it, many people are faced with a choice between two options: debt settlement and bankruptcy.

What are these two methods for dealing with high amounts of debt and how do they differ? This guide will provide the answers.

What Is Debt Settlement?

Debt settlement is when an agreement is made between a borrower and a creditor for the borrower to pay off less than the amount owed, usually in one single lump sum payment. 

For example, if someone has $20,000 of outstanding credit card debt, they might be able to negotiate a debt settlement in which they pay a single lump sum of $15,000 to clear it all.

It's important to note that this process is only done for unsecured debts, such as unsecured personal loans or credit card debt. 

How Does Debt Settlement Work?

The concept of debt settlement can be very appealing in the eyes of borrowers who are in difficult financial situations, as it essentially means that you have to pay back less than you technically owe.

However, it's important to understand that debt settlement is not a guaranteed process and it can involve a lot of risk. 

In order to begin the process, a borrower will usually seek out the services of a debt settlement firm. The firm will handle the negotiations between the borrowers and the creditor, serving as a middleman between the two parties. It is possible to negotiate directly, but many people work with firms instead.

In many cases, the settlement firm will recommend that the borrower stops paying their bills in order to save up some money so that they can propose a large lump sum payment as part of the settlement agreement. In the meantime, bills will go unpaid and the individual's credit score can start to suffer. 

After a certain amount of time, the debt settlement company will contact the creditor and suggest a negotiation for a reduced payment of the debt. At that point, it's up to the creditor to decide what they want to do. 

Some will accept settlements, preferring to get some money, rather than none at all. Others have a policy of refusing settlements and can pursue legal action against individuals who refuse to pay their bills. 

This is where the risk comes into play, as you cannot be sure that a settlement proposal will be accepted. If, however, they do accept, then you can make the lump sum payment. You'll also need to pay the fee for the debt settlement firm's services, too.

Looking for financial guidance? Refer to top financial services consultants for help.

What Is Bankruptcy?

Bankruptcy occurs when someone legally admits that they cannot afford to pay off their debts and begins a legal process in which a bankruptcy court can decide to discharge the outstanding debts. 

This process eventually clears most of the debt and protects the individual in question from creditors, giving them an opportunity to rebuild their finances all over again without having to worry about the outstanding money they owe.

However, it's important to note that not all cases end this way; some bankruptcy cases result in the borrower still having the debt but having extra time to pay it off. 

How Does Bankruptcy Work?

The process of bankruptcy is very different to debt settlement. It involves a legal admission from the borrower that they cannot pay off the debts they have accumulated, and many people believe that they can then file for bankruptcy and have their debts erased.

However, as mentioned briefly above, it's not always as simple as this. There are three forms of bankruptcy: Chapter 7, Chapter 11, and Chapter 13.  

  • Chapter 7 bankruptcy: most widely-known type and is also known as liquidation of assets bankruptcy. With this variant, the debt can be wiped.
  • Chapter 11 bankruptcy: company undergoes reorganization under a trustee. The organisation must present a plan to repay debts and reestablish profit to be approved. It often takes more than a year to define the plan itself. 
  • Chapter 13 bankruptcy: known as reorganization bankruptcy, involving the reorganization of debt to be paid off according to a three-to-five-year plan. This chapter is typically only for individuals, rather than businesses

The type of bankruptcy you can qualify for depends on your income, but either way, the process will need to go through the courts and it will ultimately be up to a judge to decide on the outcome of the case.

Debt Settlement vs Bankruptcy Compared

So what are some of the similarities and differences between the two processes? Well, let's begin with the similarities, as there aren't many of them. 

The main big similarity between bankruptcy and debt settlement is that both of these processes are designed for people in difficult financial situations, with a lot of debt. They're both aimed at helping people get rid of their debt, either by erasing it or forgiving it. 

Another similarity that both of these processes share is that they can have a severe detrimental effect on a person's credit score, making it very difficult for that individual to get approved for loans and other financial services again in the future.

The differences between the two processes are numerous. For example, they are carried out in very different ways. As explained above, bankruptcy involves judges and courts, while debt settlement is more centered around negotiation tactics and the help of settlement specialists.

Bankruptcy is therefore more of a public matter, with both Chapter 7 and 13 bankruptcies becoming part of public record. Debt settlement, meanwhile, is more of a private negotiation and settlement between borrower and creditor.

Another big difference is that, after bankruptcy, an individual is free to rebuild their finances and is protected against creditors. With debt settlement, this isn't the case, and debt collection companies can continue pursuing the borrower, issuing fees, sending letters, making calls, and so on.

Choosing Between Debt Settlement and Bankruptcy 

Knowing the difference between debt settlement and bankruptcy is key for being able to choose between them. Both of these options are considered "last resorts" for a person in debt. But if there are no other options, it's important to make the right choice. 

As this guide shows, bankruptcy can be a good choice for those who have large amounts of debt and want a fresh start, but will result in a big blow to credit status.

Debt settlement can be a preferred option for those who don't have as much debt and still have the means to bring in money and save up for a lump sum but can be a riskier option and a more stressful one.

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