Debt Settlement vs. Bankruptcy

Being overwhelmed with debt is stressful.  Month after month the bills arrive with no end in sight.  What a terrible feeling to see hundreds or thousands of dollars every month just pay interest.  The balances owed to the creditors barely budge even after the large payments!  Worse yet, many sacrifices are made in the budget to make the monthly payments.  It is very hard to escape this trap.  After many months of stress, some people start searching the internet for solutions.  A quick search on Google brings up two possible solutions: Debt Settlement or Bankruptcy.  An explanation of each is important so an informed decision can be made so time and money is not wasted.

Debt Settlement

Debt settlement Is a generic term for the strategy of not paying creditors until they settle on more favorable terms. Usually a third-party company will present a plan where you make monthly payments ranging from several hundred dollars a month to a few thousand per month (depending on how much debt you have), often over a period of three to five years. A percentage of the payments you make every month go to the company as fees for the service it provides. Fees can be as low as $2,000 or as high as $10,000 and must get paid to the company first and in full before any creditor receives any money from you.

How debt settlement works

Once you’ve signed the contract and agreed to the terms, you’re expected to start making your monthly payments to the debt settlement company (not directly to your creditors). The company’s fees get pulled from those payments. The company then negotiates with the listed creditors, who will be reporting late payments every month as the missed payments pile up.

Some creditors will accept less than the full value of their claim — but many won’t. Creditors who refuse to negotiate the debt are legally able to sue you for the full amount of the debt PLUS attorney’s fees and court costs. Any creditors that are paid less than the full amount owed are required to issue IRS Form 1099-C to you for “cancellation of debt,” which is treated as taxable income by the IRS.

While pursuing debt settlement with one of these “debt relief” companies can seem preferable to filing for bankruptcy, you need to be very careful. Each company has a fee structure and requires a contract to be signed before starting the process. In recent years these contracts have been sent to clients for electronic signature, which can be done on a cell phone. People tend not to fully read what they are signing — especially when trying to read legal jargon on a cell phone — and then only find out what they’ve agreed to months or years later. It’s very important to review this type of contract very carefully and understand all the terms before agreeing to it.

Bankruptcy advantages

Bankruptcy is a federal legal process designed to provide a fresh start to people struggling with debt. Federal law is used to prepare and file a petition with the bankruptcy court. In Chapter 7 bankruptcy, no payment is made to creditors. All of the debt is discharged by the court without the need to make any payments. In Chapter 13 bankruptcy, some payment is made to creditors. Most Chapter 13 plans pay back less than 20% of what is owed.

There are several advantages to using the power of the bankruptcy code to eliminate debt compared to seeking debt settlement through a third-party company. The bankruptcy code dictates if your debt will be fully eliminated or if there will be some repayment required; creditors have no say in what they will or won’t accept as there’s no negotiation. In most cases, nothing is repaid and the debt is eliminated. Creditors can’t refuse the plan and file a lawsuit because that would be illegal and expose them to having to pay damages.

And forgiven debt is never taxable. The IRS doesn’t get notified by creditors about canceled debt, and there’s no tax bill to pay. With large amounts of discharged debt, this can save many thousands of dollars that would have to be repaid to the IRS if you chose the debt settlement route.

Most importantly, creditors aren’t entitled to poison your credit report in a bankruptcy case like they often do in debt settlement. Credit scores can hover in the 400s after debt settlement, but most are closer to 600 after bankruptcy and can be 700 or higher after two years of rebuilding credit following bankruptcy filing with RQP Law.

Summary

Debt settlement and bankruptcy look like similar options but there are major differences between the two.  Bankruptcy eliminates debt with no repayment in many cases.  In other cases, there is some repayment.    But in all bankruptcy cases, creditors cannot poison your credit report and they cannot create tax income through sending you 1099s. It generally costs a fraction of what debt settlement companies charge as well.

If you are struggling with debt, contact RQP Law for a free consultation to discuss your legal options.