Debt Settlement vs. Bankruptcy

If you’re struggling with too much debt, two methods of debt relief can help you get out of your obligations for less than you owe: bankruptcy and debt settlement. But both options can severely damage your credit score. Bankruptcy is faster, but debt settlement may have less of an impact on your credit.

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  • Written By
    Jennifer Schell

    Jennifer Schell

    Financial Writer

    Jennifer Schell is a professional writer focused on demystifying annuities and other financial topics including banking, financial advising and insurance. She is proud to be a member of the National Association for Fixed Annuities (NAFA) as well as the National Association of Insurance and Financial Advisors (NAIFA).

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    Lamia Chowdhury
    Lamia Chowdhury

    Lamia Chowdhury

    Financial Editor

    Lamia Chowdhury is a financial editor at Lamia carries an extensive skillset in the content marketing field, and her work as a copywriter spans industries as diverse as finance, health care, travel and restaurants.

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  • Updated: May 4, 2023
  • 10 min read time
  • This page features 10 Cited Research Articles
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How Are Debt Settlement and Bankruptcy Different?

Debt settlement and bankruptcy are two different forms of debt relief. If you’re feeling overwhelmed by a large amount of debt, you might turn to these methods to help lighten your financial burden. 

During the process of debt settlement, you (or a debt settlement company) will negotiate with your creditors to pay a lump-sum settlement that’s less than the total amount you owe. If all goes well, you’ll make just one total payment. You can try to negotiate a debt settlement yourself or seek the services of a debt settlement company to negotiate on your behalf.

Bankruptcy is another method you can pursue to have your debts forgiven or discharged. When you file for bankruptcy, you’ll receive a court order that states you will not have to repay certain debts. The terms of your bankruptcy depend on the type of bankruptcy you qualify for: Chapter 7 or Chapter 13.

If you qualify for Chapter 7 bankruptcy, you’ll have most, if not all, of your unsecured debts discharged. This means you are no longer liable for the debts you owe on loans with no collateral. However, Chapter 7 bankruptcy may require you to liquidate your assets to pay off debts. With Chapter 13 bankruptcy, you won’t lose any of your assets, but you will have to complete a court-supervised repayment plan over a period of three to five years before you can have your remaining debt discharged.

Gerri Detweiler, a credit and debt expert and co-author of Reduce Debt, Reduce Stress, says that the key difference between debt settlement and bankruptcy is the time each process takes. “Chapter 7 bankruptcy is quick,” Detweiler said in an interview with “Debt settlement takes time; it could take six, 12, 24 or as long as 36 months to settle your debts.”

Detweiler also points out that bankruptcies are a matter of public record. “So it is possible someone could find out you filed for bankruptcy,” Detweiler said. “They’re not likely to find out you settled a debt unless you’re sued.”

Pros and Cons of Debt Settlement

For some people who are struggling with debt, going through the process of debt settlement can put them back on track to becoming debt-free. But for others, debt settlement can be a costly mistake. 

On the plus side, debt settlement can help you get out of debt faster because you’ll pay less than what you owe. Settling your debts can also prevent you from having to file for bankruptcy, which could have an even greater (negative) impact on your credit score.

But debt settlement has its downsides. For one, reaching a settlement can take months or even years, and there’s no guarantee that your creditors will be willing to settle at all. Settling debt also damages your credit score — and makes it harder for you to get credit in the future.

For your creditors to agree to a settlement, you’ll have to stop paying all your debts entirely. This means that your other creditors could potentially sue you for repayment if they don’t want to negotiate a settlement. And any money that’s forgiven in the settlement is considered income, so you’ll have to pay taxes on it.

Pros and Cons of Bankruptcy

If you’re considering filing for bankruptcy, the pros and cons vary depending on whether you’re filing for Chapter 7 or 13. Both types of bankruptcy can offer you a fresh start if you’re drowning in debt.

As soon as you file for bankruptcy, whether it’s Chapter 7 or 13, creditors and debt collectors must stop trying to collect your debts. So, bankruptcy can be useful if you’re tired of being hounded by calls from debt collectors.

But both types of bankruptcy can have serious consequences for your personal finance situation.

Chapter 7 Bankruptcy

Filing for Chapter 7 bankruptcy is often the quickest method of getting out of debt, and the process is relatively easy.

“Typically, if it’s Chapter 7, you wipe out most of your debts — maybe not all of them, but most of them,” said Detweiler. “And it’s a pretty fast process.”

Chapter 7 bankruptcy can take less time than other methods of debt relief, and the process is often resolved in just a few months. You may be able to get most — if not all — of your unsecured debts forgiven or discharged. This frees you from any remaining obligations, and creditors can’t garnish your wages or ask for more money in the future.

The downside of Chapter 7 bankruptcy is that your secured debts will not be so easy to discharge. You may have to surrender or liquidate your assets to settle your debts. Depending on which state you live in, the laws regarding which assets you’ll be able to keep will vary.

Another drawback with Chapter 7 bankruptcy is that not all of your debts can be discharged. If you owe child support payments, back taxes, criminal fines or some types of student debt, there’s a chance those debts may not get discharged when you file.

Chapter 13 Bankruptcy

If you file for Chapter 13 bankruptcy, you must show proof that you receive regular wages and that you can make payments on your debts for the next three to five years. The main benefit of Chapter 13 bankruptcy is that you won’t risk losing your assets like you would with Chapter 7 bankruptcy, as long as you complete the court-mandated repayment plan.

Chapter 13 bankruptcy also has less of an impact on your credit score, as it only remains on your credit report for seven years. And if you’re facing foreclosure on your home, filing for Chapter 13 can halt the foreclosure process and give you time to catch up on payments.

However, if you can’t prove that you earn consistent wages or if you fail to make payments, Chapter 13 bankruptcy may not be right for you. Chapter 13 also takes much longer, as you must continue paying down your debts for a period of three to five years.

When To Consider Debt Settlement or Bankruptcy

Deciding whether debt settlement or bankruptcy is right for you will depend on your own financial situation. Here are some things to consider when deciding which debt relief strategy you should pursue.

If you can save up enough money to settle your debts in a lump sum, you may want to try to do so. Debt settlement works best if you’re already behind on your bills, as creditors are less likely to accept a settlement if you’ve been making payments consistently.

You may also benefit from debt settlement if your financial situation is likely to change in the future, as bankruptcy requires you to report any changes in your income to the trustee. With debt settlement, you keep paying the same amount even if your income increases.

But if you can’t afford a lump sum settlement, bankruptcy may be the right option for you. Chapter 7 bankruptcy can make those debts go away completely, while Chapter 13 gives you three to five years to pay down any remaining debts.

Going through Chapter 7 bankruptcy can be a fast way to get a fresh start on your finances, debt-free. However, if you’re concerned about your bankruptcy being part of the public record and others finding out about it, you may not want to file for Chapter 7 bankruptcy. You may also want to avoid it if you have assets you want to keep, or if you have a professional license that could be jeopardized.

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Credit Impact of Bankruptcy and Debt Settlement

Both debt settlement and bankruptcy can negatively affect your credit score. But the severity of the impact and the length of time your credit takes a hit will depend on the type of debt relief you choose, in addition to other factors. Let’s compare how bankruptcy and debt settlement can affect your credit score.

Credit Score After Bankruptcy

Filing for bankruptcy can severely damage your credit, no matter which type you file for.

“Chapter 7 and Chapter 13 are both negative items on your credit report,” Detweiler explains. “Chapter 7 remains for 10 years from the date you file. Chapter 13 stays on [your report] for seven years from the date you file, provided you complete it. If you don’t complete it, then it’ll end up staying for a 10-year period.”

Despite this long timeline, bankruptcy doesn’t have to mean you trade a lifetime of debt for a lifetime of bad credit. “I think what people don’t often realize with bankruptcy is that as soon as your bankruptcy is discharged, as soon as it’s done, you can start rebuilding credit right away,” Detweiler says.

Detweiler suggests using traditional credit-building methods such as getting a secured credit card or asking a friend or family member to add you as an authorized user on their credit card. “There are even car loans for people with bankruptcy,” she says. “So even though it’ll stay on your credit report for 7 to 10 years, it doesn’t mean you can’t get credit for 7 to 10 years.”

Credit Score After Debt Settlement

Debt settlement can also negatively impact your credit score. When you start the process of debt settlement, you have to stop making payments on any unsecured debts, including debts not involved in the settlement. 

This is because creditors can look at your credit report to see which payments you’re making. “If you’re paying everyone else on time and not them, it’s going to be less favorable for [your creditors] to negotiate,” says Detweiler.

Eventually, your debts will be converted to “charge-off status” after about six months, which means your creditors have written them off as bad debts but can still collect them. Or the creditors might sell the debt to a collection agency, and you’ll have to negotiate a settlement with those agencies. Either way, Detweiler says, “You’re going to have a bunch of late payments and negative items on your credit report, and that’s going to hurt your credit.”

If you’ve already fallen behind on paying your debts, the impact on your credit score might be lessened when you go through debt settlement.

“If you’re already missing payments, then your credit’s already reflecting that. It could get worse for a time, but eventually you start settling these debts,” Detweiler says.

Additionally, you may be able to negotiate as part of your settlement that the collection agency stop reporting your missed payments to the credit bureaus.

Besides the missed payments, settling debt means you aren’t paying the full amount owed. Not making payments as agreed to is another factor that can harm your credit score, and this information can stay on your credit report for up to seven years.

Can You File For Bankruptcy After Debt Settlement?

Many people consider bankruptcy a last resort, and they’ll often exhaust all other debt-relief options —including going through debt settlement — before filing. It’s not uncommon for someone to try to file for bankruptcy when they’re still trying to pay off debt after negotiating a settlement.

If you’re eligible for Chapter 7 bankruptcy, the unsecured debts you get discharged can be an original agreement or an agreement you’ve negotiated during a debt settlement. However, debt settlement can make the process of filing for bankruptcy even more complicated. 

The process gets more complicated because bankruptcy requires that you not give preference to one creditor before you file. If you’ve already settled a debt with one of your creditors and then decide to file for bankruptcy, the bankruptcy trustee could try to rectify the preference to the creditor by raising your monthly payment to make up for the earlier settlements. They might also take back your settlement payments and distribute that money to all your creditors.

Making Your Decision

When it’s time to decide how you want to proceed with debt relief, it’s a good idea to get perspectives from both sides. “I always recommend anyone who’s considering debt settlement to at least talk to a bankruptcy attorney,” Detweiler says. “Sometimes bankruptcy is a better option for just getting it over with.”

Ultimately, figuring out the right method of debt relief will come down to what’s most important to you. If resolving your debt as quickly as possible is your top priority, then filing for Chapter 7 bankruptcy may be the best solution. Filing for some form of bankruptcy may also be the most affordable option if you’re able to get most, or all, of your debts discharged.

However, if you’re more concerned about getting out of debt and preserving your credit score (and your ability to get credit in the future), you may be better off trying to settle your debts. Debt settlement might also be the better option if you have old debt that’s gone to collections, as you’re more likely to be able to negotiate a lower settlement.

If you have extenuating circumstances — like a foreclosure or vehicle repossession — your best course of action is probably to file for Chapter 13 bankruptcy. Chapter 13 pauses these processes and gives you time to catch up on your payments while completing a court-ordered repayment plan.

Please seek the advice of a qualified professional before making financial decisions.
Last Modified: May 4, 2023

10 Cited Research Articles writers adhere to strict sourcing guidelines and use only credible sources of information, including authoritative financial publications, academic organizations, peer-reviewed journals, highly regarded nonprofit organizations, government reports, court records and interviews with qualified experts. You can read more about our commitment to accuracy, fairness and transparency in our editorial guidelines.

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