Debt Relief vs Bankruptcy

Managing crippling levels of personal debt is an unfortunate fact of life for too many Americans. Raised consumer prices and higher housing and transportation costs combine with static incomes, hefty credit card balances, and other monthly obligations to create a perfect storm of debt.

The two primary solutions to such tough times are debt relief and bankruptcy. But these options chase the same result in different ways.

Before you embark on either path, learn the key differences between them and how they will affect your short- and long-term financial futures.

What Is Debt Relief?

Debt relief can mean many things, but it mostly refers to products, services, and tools that can help you reduce or manage your debt. It includes various methods to change the terms or amount of your debt and make it more manageable.

Debt relief can:

• Reduce the dollar amount of the debt
• Lower the interest rate on the debt
• Consolidate debt from different creditors into one payment

Whatever form debt relief takes, the goal is to ease your monthly financial burden while also handling your obligations and pushing toward long-term financial stability.

Types of Debt Relief

You can pick from several types of debt relief, including debt settlement, debt consolidation, credit counseling, and bankruptcy. The best solution depends on what you most need help with.

Details about debt relief are:

• Credit counseling is often the first resort for people who need expert guidance from certified debt counselors on budgeting, finances, and creating manageable repayment plans.
• Debt consolidation involves using one large loan to pay off multiple smaller debts, usually with a lower interest rate so that you’re left with one manageable monthly payment.
• Debt settlement involves negotiating with your creditors so that you can pay off your debts for less than what you owe.
• Bankruptcy is (and should be) the action of last resort. It is a court-approved process of wiping away all your debt to get a fresh financial start. However, the consequences are severe and last years.

Credit Counseling

Credit counseling involves working with a certified counselor who reviews your budget, spending habits, credit, and debt level. The counselor then recommends a holistic approach to managing debt, avoiding financial emergencies, building credit, and developing sound habits.

The key part of the process is creating a workable debt management plan and offering education on basic budgeting issues to avoid future debt issues.

A debt management plan (DMP) is a form of debt consolidation. It works by lowering the interest rates on your credit cards, thus lowering your monthly payment, and combining your credit card payments into one bill. You pay the credit counseling agency, and they distribute the funds to your creditors for you.

Non-profit groups offer this service. Credit counseling is free, though there is a fee if you choose to enroll in a debt management plan.

Debt Consolidation

As its name suggests, debt consolidation is consolidating multiple debts and replacing them with one combined larger debt with the goal of making payment more manageable and affordable. The process involves taking out a new loan, usually at a lower interest, and using it to pay off the other existing smaller debts. That leaves you with only one monthly bill to handle.

You can merge your debt in several ways, including a debt consolidation loan, transferring your credit card debt to a no-interest or low-interest credit card, securing a home equity loan, or getting a home equity line of credit (HELOC).

All these options can get you a lower interest rate — if you qualify. Although the result might lower your monthly payments, before you agree, make sure you weigh the amount you save in interest vs. the fees that typically come with debt consolidation.

Also, after you sign an agreement, you must maintain timely payments on the new loan to avoid causing more damage to your credit.

Debt Settlement

Never confuse debt settlement — also known as debt negotiation and debt arbitration — with credit counseling or debt management programs. In debt settlement, you (or your representative) ask your creditors (usually credit card companies) to accept part of what you owe as payment in full.

Having available cash and the ability to make a one-time partial payment soon will help your negotiations. Creditors have accepted 40% to 70% of the balance to write off the remaining debt.

Many times, however, cash is not an option. People can turn to debt settlement companies for help. These companies:

• Put their clients on a budget.
• Order them to make no more payments on their unsecured (credit card, medical, personal loan) debt.
• Order regular deposits to be placed in an escrow account.
• Use accumulated money to make an offer to settle the debt.
• Pay themselves. Debt settlement company fees could be as much as 20%-25% of your original debt.

Debt settlement is a long process and will damage your credit score, but you can come out in the end with no debt. However, research the company you pick to do business with.

“Not all debt settlement companies are created equal,” says credit industry analyst Greg Mahnken of Liverpool, N.Y. “Read reviews and understand all of the costs and terms of your agreement before enlisting a debt settlement company to help you.”

Pros and Cons of Debt Relief

Debt relief presents a workable solution and a fresh start for anyone struggling to manage their monthly obligations. However, debt relief can have many downsides, including credit damage, tax consequences, fees, and penalties. Here is a detailed look at the pros and cons of debt relief.

Pros of Debt Relief

• Avoiding bankruptcy. Debt relief offers a way to manage debt without resorting to bankruptcy, which can have more severe and long-lasting consequences.
• Lower interest rates and monthly payments. Some debt relief options, such as a consolidation loan or a debt management plan, can reduce the amount of interest you owe or secure a reduced monthly payment.
• Faster debt resolution. Debt relief programs like debt consolidation can help you become debt-free faster than if you continued making minimum payments in your current situation.
• Professional help. Credit counseling and debt management programs can guide you on how to build an affordable budget, tame your spending habits, clean up your credit reports, and explore different debt relief options for your long-term financial wellbeing.
• Access to free help. Although some organizations charge a fee for certain services, non-profit organizations offer credit counseling at no charge.

Cons of Debt Relief

• Potential damage to your credit score. Debt settlement can lower your credit score. Even if you eventually clear the debt, your decision remains on your credit report for several years and can make it difficult to get approved for loans at competitive rates in the future.
• Fees for debt relief services. Most debt relief services come at a fee. Besides the fees on services and financing products, you might also have to pay late fees, interest charges, and other penalties, as is often the case with debt settlement.
• No guarantee. Although lenders are usually willing to work with you to resolve debts, they’re under no obligation to do so. There’s no guarantee that creditors will agree to your terms of debt settlement.
• Tax consequences. If a creditor forgives all or part of your debt of more than $600, the IRS considers the forgiven debt amount as income. So, you eventually must pay taxes on it. The creditor is then required to send you a form 1099-C, which shows the original debt and how much debt it forgave.
• Potential for increased debt. Interest and penalties may continue to accrue during the negotiation period of a debt settlement program, which might increase your overall debt.

What Is Bankruptcy?

Bankruptcy is a legal process that helps people and businesses reduce, restructure, or eliminate their debt under court supervision. Because of its impact on your financial future, bankruptcy should be your last resort. However, it can offer you a fresh start if you are truly out of options.

Types of Bankruptcy

For individuals, there are two primary types of bankruptcy, Chapter 7 and Chapter 13. Filing for bankruptcy involves petitioning a bankruptcy court through an attorney and then undergoing a means test to determine if you qualify.

With Chapter 7 bankruptcy, all debts get removed. With Chapter 13 bankruptcy, most debts get repaid, although some could get discharged by the court.

Chapter 7 Bankruptcy

Chapter 7 filings are usually what we have in mind when we think of bankruptcy.

You gather your bank statements, loan documents, pay stubs, and credit card statements and fill out a bankruptcy petition, statement of financial affairs, payment schedules, and other required documents. These will get filed with the court.

Once approved, a court-appointed trustee will sell your assets — except for certain exempt properties kept to aid your fresh start. Sale proceeds will get distributed to creditors who filed legal claims to your debt. However, most Chapter 7 cases result in no assets being sold.

In the end, the debts addressed by your straight/liquidation bankruptcy (exceptions apply) vanish.

“Bankruptcy,” says attorney and CEO of LegalAdvice.com David Reisher, “provides considerable relief for anybody overwhelmed with unsustainable levels of debt.”

Chapter 13 Bankruptcy

In Chapter 13 bankruptcy — also called a wage earner’s plan — consumers don’t get their debts wiped away. Instead, debts get reorganized under a repayment plan that stretches from three to five years. Some creditors may be repaid in full. Some may not.

Like a debt management plan, a Chapter 13 bankruptcy pays a monthly sum to a trustee, who distributes payments to creditors according to priorities set by the court.

“Because you pay back at least some of what you owe, it’s considered a bit more respectable when you apply for credit in the future,” says Gina Pogol, a personal finance specialist with MoneyRates.com. “Chapter 13 bankruptcy offers all of the benefits of a debt settlement plan, but you also get tax-free debt forgiveness, all interest and fees stop piling up, collection efforts stop and when you’re finished, you are free of debts.”

Pros and Cons of Bankruptcy

While bankruptcy offers a new financial beginning for people overwhelmed by debt, it also brings significant consequences. Here is a closer look at the pros and cons of filing for bankruptcy.

Pros of Bankruptcy

• A fresh start. Most debtors who file for bankruptcy have no viable way to repay their debt. Filing for bankruptcy allows you to discharge most of your unsecured debts, thus giving you a clean slate to rebuild your finances.
• Immediate relief. Upon filing for bankruptcy, the court issues an automatic stay, which stops creditors from making further collection attempts on your debts. This will give you much-needed relief from having to deal with overbearing creditors.
• Protection from creditors. The automatic stay also provides temporary legal protection from foreclosure, eviction, further wage garnishments, and car repossession. Any wages you earn after filing for bankruptcy are not part of the bankruptcy estate and thus cannot be used to repay creditors for any discharged debt. You may also protect key assets, such as your retirement savings and personal items.

Cons of Bankruptcy

• You will experience long-term credit damage. Filing for bankruptcy is one of the most damaging events on your credit. After all, it shows that you can’t honor your obligations. This record stays on your credit report for seven years (Chapter 13) to 10 years (Chapter 7), which might make it difficult to get credit in the future.
• You will damage your financial reputation. Bankruptcy filings are public records, which can affect your personal and professional reputation, including your ability to get certain jobs or even rent some apartments.
• You could lose assets. While bankruptcy protects exempt assets like your house and personal effects, Chapter 7 requires that all non-exempt assets be sold to repay the creditors. In Chapter 13, although you get to keep your assets, the value of non-exempt and luxury assets is used to negotiate a repayment plan.
• Eligibility is limited. To qualify for bankruptcy, you need to pass a means test. Not everyone can discharge their debt under bankruptcy.
• There is limited availability. You can only file for bankruptcy once every eight years under Chapter 7 and two years under Chapter 13.
• Not all debts are dischargeable. You cannot discharge certain debts, such as student loans, child support, and recent taxes under bankruptcy.
• It is expensive. Filing for bankruptcy requires you to hire an attorney and pay court fees upfront which can be very.

Key Differences Between Debt Relief and Bankruptcy

There are key differences between bankruptcy and debt relief to be aware of.

The biggest differences between debt relief and bankruptcy are:

• The process: Bankruptcy is a formal legal proceeding that is overseen by a federal bankruptcy court and which may require your court appearance before a judge. You will need to hire an attorney in order to file bankruptcy with the filing becoming public record. In contrast, debt relief programs such as debt settlement are typically private negotiations between you (or your contracted debt settlement company) and your creditors.
• Impact on credit: While both options can negatively affect your credit score, bankruptcy has a more severe and long-lasting impact — remaining on your credit report for seven to 10 years. With debt relief, your credit score may recover sooner than with bankruptcy.
• Debt discharge: Bankruptcy can cause the complete discharge of certain unsecured debts. In contrast, under debt relief, you will still be under obligation to repay a portion of your debts.
• Asset protection: Although Chapter 13 bankruptcy allows you to retain your assets, Chapter 7 bankruptcy requires that you sell off non-exempt assets to repay your creditors. In contrast, debt relief does not require you to sell off any of your assets to satisfy your creditors.
• Duration: A Chapter 7 bankruptcy filing typically takes three to six months, while Chapter 13 takes three to five years to complete. In contrast, the timeline for debt relief programs depends on your specific situation.
• Creditor participation: In bankruptcy, your creditors are bound by court decisions and will stop collection efforts immediately after you file. In contrast, debt relief programs require the voluntary participation of your creditors, and they are under no obligation to accept your terms.
• Cost: Fling for bankruptcy requires you to hire an attorney and pay court fees up-front, which can be costly. In contrast, debt relief programs may have lower up-front costs, but you might have to bear more fees (service fees and late fees) and penalties spread out.

Factors to Consider When Choosing Between Debt Relief and Bankruptcy

If you face the decision of choosing between debt relief and bankruptcy, consider some key factors.

Consider these differences between debt relief and bankruptcy:

• Amount of debt: If your debt is relatively manageable, debt relief might be more appropriate for you. However, if you are facing overwhelming debt that you have no hope or conceivable way of repaying, even after your interest rates are lowered or your principal balances lowered, bankruptcy might be the better choice.
• Income level: Your level of income affects your eligibility for bankruptcy and your ability to complete a debt relief program. While having a higher and stable income might disqualify you from Chapter 7 bankruptcy, it could make you a suitable candidate for Chapter 13 bankruptcy or debt relief programs. If your income is limited or unstable, Chapter 7 bankruptcy might be more suitable.
• Asset protection: If you own significant assets that you want to protect, such as a home with substantial equity, cars, savings, retirement accounts, and other valuables, debt relief or Chapter 13 bankruptcy might be preferable to Chapter 7, which could require liquidation of non-exempt assets.
• Long-term financial goals: Although both options dent your credit score, bankruptcy’s impact is more severe and remains on your credit report for seven to 10 years, potentially affecting your future loan applications, housing options, and even employment opportunities in some fields.
• Legal implications: Bankruptcy provides legal protections that debt relief programs do not offer. If you are facing wage garnishment or harassment and lawsuits from creditors, the automatic stay that comes with bankruptcy might be valuable.
• Types of debt: Bankruptcy is effective for discharging unsecured debts like credit cards and medical bills. However, it cannot discharge certain types of debt, such as student loans and recent taxes. If these types of debt make up much of your debt, debt relief programs might be more beneficial.

Most importantly, remember that there is no “one-size-fits-all” solution to managing debt. Your individual circumstances play a central role in determining your best course of action. Given the complexity and severe long-term consequences of both debt relief and bankruptcy, it is only wise to seek professional help and guidance to make an informed decision. Consider consulting with a non-profit credit counseling agency, a financial advisor, or a bankruptcy attorney.

Choosing the Right Path

Both debt relief and bankruptcy provide potential solutions for anyone trying to manage overwhelming debt. Each solution presents unique benefits and drawbacks that you will want to consider before choosing a course of action.

Bankruptcy offers immediate relief although the long-term consequences might be undesirable to some people, while debt consolidation or any kind of debt settlement might give you the breathing space you need to reorganize your finances and clear your financial obligations.

If you’re still unsure of the route to take, it might help to speak to a certified credit counselor who can recommend the best route based on your unique circumstances. Check with the Financial Counseling Association of America (FCAA) or the National Foundation for Credit Counseling (NFCC) to find a certified credit counselor near you.