Debt Relief vs. Bankruptcy: Understanding Your Options (2024)

When debt becomes overwhelming, debt relief and bankruptcy are two options for getting your life back on track. They work differently, and each has its pros and cons. Debt relief can involve consolidation and debt counseling, which involves lowering the cost of repayment but also debt settlement which involves repaying less than is owed in a negotiated settlement with lenders. Bankruptcy involves seeking protection from creditors for debt that can not be repaid. Here is what you need to know if you're trying to choose between them.

Key Takeaways

Debt relief can involve debt settlement, debt consolidation, or credit counseling.
Bankruptcy is a court-supervised legal process for individuals or businesses to eliminate their debts or repay them over time.
Debt relief can help individuals manage their debts and avoid bankruptcy, but it can harm their credit if it involves debt settlement with lenders for less than is owed.
Bankruptcy also has negative credit consequences that can last for years.

Understanding Debt Relief

Debt relief comes in several forms. It may involve consolidating your debts or negotiating with creditors for a lower interest rate or longer payment term, having fees waived, or settling your debt for a reduced amount. These are some of your options:

Debt consolidation

Debt consolidation involves bringing all your debt together into one account to make the payment more manageable and affordable. There are several methods for consolidating debt, such as a debt consolidation loan, a personal loan, a home equity loan, a home equity line of credit (HELOC), or transferring your credit card debt to a no- or low-interest credit card.

If you qualify, these options can often get you a lower interest rate on your debt. However, they typically carry fees that you'll need to weigh against the amount they save you in interest.

Credit counseling

As the name implies, credit counseling involves meeting with a counselor to analyze your debt and the income you have available to pay it. The credit counselor can help you create a budget for paying down your debt while meeting your other financial obligations.

In some cases, a credit counselor may help set up payment agreements with your creditors in which the creditor holds off on collection efforts or waives late fees during the term of the agreement. Credit counselors do not negotiate to reduce your debt. Some credit counselors may devise a debt management plan that requires you to make your monthly payment to the counseling organization, and the organization then pays your creditors.

Credit counseling is offered by nonprofit organizations such as the National Foundation for Credit Counseling. Some organizations charge a fee for their services, while others do not.

Debt settlement

In a debt settlement, the creditor agrees to accept a reduced amount as payment in full on the account. You can negotiate with the creditor yourself or hire a debt settlement company to do so on your behalf.If you want to go the latter route, be sure to check the company out thoroughly; this is an area that is rife with scams.

Debt settlement can be a lengthy process, taking months or years to resolve, and your creditors have no legal obligation to negotiate with you. Instead, they may turn your account over to a collection agency or even sue you.

A debt settlement, if you're successful in arranging one, will remain on your credit reports for up to seven years and harm your credit score, making it more difficult to obtain credit in the future. In addition, you may be required to pay income tax on any amount you manage to have forgiven.

Benefits and Drawbacks of Debt Relief

Type of Debt Relief	Pros	Cons
Debt consolidation	Can turn multiple payments into one single payment. Could get you a lower interest rate on your total debt. Monthly payment could be lower, allowing you to pay debt back faster.	Upfront fees could outweigh any cost savings. In the case of a home equity loan or line of credit, your home serves as collateral and is at risk if you can't pay the money back.
Credit counseling	Can help you create a budget and repayment plan. May help negotiate a repayment agreement with your creditors. May be free or low-cost.	Won't negotiate to lower your debt. Creditors may not agree to the debt management plan. Some organizations that call themselves credit counselors are not reputable.
Debt settlement	Can settle your debt for less than you owe—if creditor agrees.	Credit score will take a major hit. Debt settlement companies may charge high fees and aren't always successful. You may owe income tax on any forgiven amounts.

Debt settlement can result in tax consequences because most forgiven debt is considered regular income by the IRS and must be declared by the taxpayer. Forgiven debt above $600 is required to be reported to the IRS by lenders.

Understanding Bankruptcy

Bankruptcy offers people a way to get out of debt by either liquidating their assets to pay off their debts or creating a repayment plan that allows them to keep their assets while they pay off debt.

There are several types of bankruptcy available to individuals, businesses, and government entities. For individuals, the two primary types are Chapter 7 and Chapter 13. (Chapter 11 can also be available to individuals in some instances but is primarily used by businesses.)

Chapter 7bankruptcy

With Chapter 7, known as a "liquidation" bankruptcy, the individual files for bankruptcy and the court assigns a bankruptcy trustee to the case. The trustee will sell off any of the debtor's nonexempt assets and use the proceeds to pay off their creditors, often for pennies on the dollar. After that, the debtor is released from any obligation to repay the remaining debt. Certain debts, however, such as child support, alimony, student loans, and taxes, are not eligible for discharge through bankruptcy.

Chapter 13 bankruptcy

In a Chapter 13 bankruptcy, known as a "reorganization," the debtor gets to keep their assets but must agree to a repayment plan with a term of three to five years. Those payments are then made to a bankruptcy trustee, who distributes the money under the plan. Some debts may be paid in full, but others may not. Some debts can be discharged if the debtor makes all payments according to the repayment plan.

Benefits and Drawbacks of Bankruptcy

Type of Bankruptcy

Pros

Cons

Chapter 7

May discharge most debts, allowing you a fresh start.

Usually takes just 3 to 6 months to complete.

Debt collections must cease.

Stops any foreclosure proceedings on your home.

Assets, with some exceptions, will be liquidated to pay creditors.

Not everyone qualifies.

Certain debts cannot be discharged.

Stays on credit reports for up to 10 years.

Chapter 13

Gives you a longer time to repay creditors.

Foreclosure and repossession actions cease.

Assets won't be liquidated.

Could take up to 5 years to repay debts.

Must cease use of existing credit cards.

Stays on credit reports for up to seven years.

Debt Relief vs. Bankruptcy: Key Differences

Debt relief and bankruptcy both provide ways to deal with unmanageable debt levels but, as noted above, work differently. In particular, debt relief is often handled privately, while bankruptcy involves the court system.

Both debt relief (when in the form of debt settlement) and bankruptcy can negatively affect your credit score, but the impact of debt relief could be less damaging. With debit relief, your credit score may drop, but it will begin to recover once you start rebuilding your credit. Bankruptcy, however, will remain on your credit report for as long as 10 years in the case of Chapter 7 and seven years in the case of Chapter 13.

Factors to Consider When Choosing Between Debt Relief and Bankruptcy

When deciding between debt relief and bankruptcy, there are several factors to consider. These include:

Amount of debt. Bankruptcy should be a last resort, to be used only if your debt exceeds your ability to ever repay it.
Income level. If you have a sufficient income, debt relief may be more effective than bankruptcy, especially if you make too much to qualify for Chapter 7 protection.
Future financial goals. If you have plans to buy a home, start a family, or pursue some other big life goal, having a bankruptcy on your record could make that more difficult.
Privacy. If you want to keep your financial situation to yourself, remember that bankruptcy is a matter of public record.

Debt Relief vs. Bankruptcy Examples

Choosing between debt relief and bankruptcy isn't always an easy decision. Here are some examples that may provide clarity.

Debt relief is likely to be the best course if:

You have a stable income that's sufficient to cover your regular bills as well as any payments required under a debt relief program.
You are willing to negotiate with your creditors on a repayment or settlement plan (and they are willing to accept one).
You have the financial discipline to stick to a debt relief program without taking on new debt.

Bankruptcy is likely to be the best course if:

You have no steady income to make payments under a debt relief program, or your income is inadequate.
Your home is under threat of foreclosure.
Your debt exceeds your income and savings to the point that you have no reasonable possibility of getting out of debt within a reasonable timeframe.
You have exhausted all avenues of debt relief and still have high levels of debt you can't repay.

How Does Debt Relief Affect Credit Scores?

Debt relief could lower your credit score because some programs require you to close your credit card accounts as part of the process. This will reduce your available credit and raise your credit utilization ratio, which will have a negative impact of your credit score. If you settle with creditors for less than you owe, those accounts may be reported as "settled accounts," which also will damage your score. However, these effects usually are short term, with your credit score gradually rebounding as you rebuild your credit with regular on-time payments.

How Long Does Debt Relief Stay on Your Credit Report?

The type of debt relief program you choose determines how long it stays on your credit report. For instance, debt settlement plans stay on your credit report for seven years. However, if you negotiate a repayment plan with your creditors before the account is delinquent and then make on-time payments going forward, your credit report may stay clean.

Does Bankruptcy Clear All Debts?

There are certain debts bankruptcy does not do away with, including child support, alimony, student loans, and taxes.

What Do You Lose if You Declare Bankruptcy?

Even in a Chapter 7 liquidation bankruptcy, you may be able to keep some assets, referred to as "exempt property." While the list can vary from state to state, it might include equity in your home and car, the money in your retirement plans, your clothes, and home furnishings. Before declaring bankruptcy it would be worth consulting a bankruptcy attorney who is familiar with the rules in your particular state.

Are There Alternatives to Debt Relief and Bankruptcy?

If you can find a way to come up with more money to pay your debts, you might be able to avoid both debt relief and bankruptcy. Some possibilities include getting a second job to bring in extra income, selling off possessions you don't need, or borrowing from a relative who's willing to help.

The Bottom Line

Both debt relief programs and bankruptcy have benefits and drawbacks you'll want to consider before embarking on a course of action. A good starting point is to talk with a qualified credit counselor at a nonprofit organization to determine what your options are. To find a credit counselor near you, check with the Financial Counseling Association of America or the National Foundation for Credit Counseling.

Debt Relief

Debt relief comes in several forms, including debt consolidation, credit counseling, and debt settlement. Here are some key points about each:

Debt consolidation: Debt consolidation involves combining all of your debts into one account to make the payment more manageable and affordable. This can be done through methods such as a debt consolidation loan, a personal loan, a home equity loan, a home equity line of credit (HELOC), or transferring credit card debt to a no- or low-interest credit card. Debt consolidation can often result in a lower interest rate on your debt, but it typically carries fees that should be weighed against the amount saved in interest [[1]].

Credit counseling: Credit counseling involves meeting with a counselor to analyze your debt and income in order to create a budget for paying down your debt while meeting other financial obligations. Credit counselors can help set up payment agreements with creditors and may devise a debt management plan where you make monthly payments to the counseling organization, which then pays your creditors. Credit counseling is offered by nonprofit organizations, and while some charge a fee for their services, others do not [[1]].

Debt settlement: Debt settlement involves negotiating with creditors to accept a reduced amount as payment in full on the account. This can be done by yourself or through a debt settlement company. However, it's important to thoroughly research any company you consider working with, as the debt settlement industry has been known to have scams. Debt settlement can be a lengthy process, and success is not guaranteed. It can also have negative consequences on your credit score and may result in tax obligations on any forgiven amounts [[1]].

Bankruptcy

Bankruptcy is a legal process that provides individuals and businesses with a way to eliminate or repay their debts. There are different types of bankruptcy, but for individuals, the primary types are Chapter 7 and Chapter 13.

Chapter 7 bankruptcy: Also known as "liquidation" bankruptcy, Chapter 7 involves selling off the debtor's nonexempt assets to pay off creditors. After the assets are liquidated, the debtor is released from any obligation to repay the remaining debt. However, certain debts such as child support, alimony, student loans, and taxes are not eligible for discharge through bankruptcy [[1]].

Chapter 13 bankruptcy: Chapter 13 bankruptcy, also known as "reorganization," allows the debtor to keep their assets while agreeing to a repayment plan with a term of three to five years. Payments are made to a bankruptcy trustee, who distributes the money according to the plan. Some debts may be paid in full, while others may not. If the debtor makes all payments according to the repayment plan, some debts can be discharged [[1]].

Key Differences and Considerations

Here are some key differences and factors to consider when choosing between debt relief and bankruptcy:

Credit impact: Both debt relief and bankruptcy can negatively affect your credit score. However, the impact of debt relief may be less damaging, as your credit score may begin to recover once you start rebuilding your credit. Bankruptcy, on the other hand, can remain on your credit report for up to 10 years (Chapter 7) or seven years (Chapter 13) [[1]].
Amount of debt: Bankruptcy should be considered as a last resort when your debt exceeds your ability to repay it. If you have a sufficient income, debt relief may be a more effective option [[1]].
Future financial goals: Having a bankruptcy on your record could make it more difficult to achieve certain financial goals, such as buying a home or starting a family [[1]].
Privacy: Bankruptcy is a matter of public record, so if you prefer to keep your financial situation private, debt relief may be a better option [[1]].

Examples

Here are some examples that may help clarify when debt relief or bankruptcy may be the best course of action:

Debt relief may be the best course if you have a stable income, are willing to negotiate with creditors, and have the financial discipline to stick to a debt relief program without taking on new debt [[1]].
Bankruptcy may be the best course if you have no steady income, your home is under threat of foreclosure, your debt exceeds your income and savings, or you have exhausted all avenues of debt relief [[1]].

Impact on Credit Scores and Credit Reports

Debt relief can lower your credit score, especially if it involves closing credit card accounts or settling accounts for less than what is owed. However, these effects are usually short-term, and your credit score can gradually rebound as you rebuild your credit with regular on-time payments. The type of debt relief program you choose determines how long it stays on your credit report. For example, debt settlement plans stay on your credit report for seven years [[1]].

Bankruptcy, on the other hand, has a more significant and longer-lasting impact on your credit score and credit report. Chapter 7 bankruptcy stays on your credit report for up to 10 years, while Chapter 13 bankruptcy stays on your credit report for up to seven years [[1]].

Alternatives to Debt Relief and Bankruptcy

If you can find a way to come up with more money to pay your debts, you may be able to avoid both debt relief and bankruptcy. Some alternatives include getting a second job, selling off possessions you don't need, or borrowing from a willing relative [[1]].

In conclusion, debt relief and bankruptcy are two options for individuals struggling with overwhelming debt. Debt relief involves methods such as debt consolidation, credit counseling, and debt settlement, while bankruptcy is a legal process for eliminating or repaying debts. It's important to carefully consider the pros and cons of each option and assess your own financial situation before making a decision.