Debt Settlement vs. Bankruptcy: Which is Right for You?

Debt Settlement vs. Bankruptcy: Which Is Right For You?

Debt settlement and bankruptcy are solutions to the same problem – What are the most direct methods for getting out of debt? — but they can take very different tolls on your future financial well-being. If your debts are so massive that you can’t imagine repaying them, it’s time to consider both options.

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Bankruptcy can offer the fastest path out of debt, but the long-term impact on your creditworthiness is severe. A bankruptcy will stay on credit reports from seven to 10 years, which will greatly impede your ability to get a loan, receive a credit card or buy a home. Bankruptcy, which is adjudicated in federal court, either wipes out your personal debt (Chapter 7) or creates a plan for repaying creditors (Chapter 13).

Debt settlement doesn’t require a court filing and, unlike bankruptcy, can often be handled without a lawyer or financial counseling. A settlement is a deal you negotiate with creditors to pay less than the amount owed.

Why would creditors want to settle your debts for less than you owe?

They know that you can always file for bankruptcy, which could eliminate their ability to collect anything from you. So, they are frequently willing to accept less than they are owed through debt settlement.

If you conclude that you can’t even afford debt settlement, bankruptcy could be the best option.

Personal bankruptcy comes in two varieties: Chapter 13 is essentially a payment plan that takes three to five years; Chapter 7 clears your personal debts but comes with potential pitfalls. If you own a home, you will be able to keep it under Chapter 13, though you will need to make mortgage payments after you exit bankruptcy court. Chapter 7 doesn’t offer that guarantee. Some states allow bankruptcy trustees to sell your home to raise money to repay creditors. Chapter 7 also has income limits that requires you make less than your state’s median income for a family your size.

Bankruptcy frees you from debt collection, but the headaches can linger for years. Debt settlement without bankruptcy can take more time, but if negotiated properly can do far less damage to your credit. Understanding the pros and cons of debt settlement vs. bankruptcy and making the smartest choice can have a big impact on your future finances.

Choosing Debt Settlement or Bankruptcy

Fred had fallen far behind in his credit card payments – so far that he could barely make the monthly minimum payments. His income wasn’t increasing yet his bills were rising. Fred rightly concluded that something had to change, or he would eventually have to file for bankruptcy.

Fortunately, Fred determined that if he stopped paying his credit card bills, he could still afford to pay his mortgage. He even had enough money to save a little. After seeing a credit counselor, he decided that debt settlement might work. He stopped paying his credit card bills, notifying the card companies that he couldn’t keep up. Fred used a debt settlement company to negotiate with creditors and consolidate his debt into a single payment. The creditors accepted a greatly reduced debt, agreed not to report the settlement to the credit-rating agencies and allowed the settlement company to collect monthly payments from Fred until the debt was settled.

Fred was able to clear his debts within a year and avoid severe damage to his creditworthiness.

Janet’s problem was different. Like Fred, she was deep in credit card debt, but she had other problems. Her husband lost his job and was having trouble finding a new one. Janet’s income was barely enough to cover the mortgage, let alone make monthly minimum payments on her cards. Then, her husband suffered a heart attack and the medical bills were completely unaffordable.

After considering the options, Janet and her husband decided to file Chapter 7 bankruptcy. State law protected his home from foreclosure if she made payments, and it wiped her other debts clean. In Janet’s case, a debt settlement wouldn’t have helped, since she and her husband couldn’t save enough to settle. Bankruptcy was the only reasonable way out.

Impact of Bankruptcy and Debt Settlement on Credit

Both bankruptcy and debt settlement can have an adverse impact on your creditworthiness and can lower your credit, or FICO, score for years. Bankruptcy, no matter which chapter you file under, is certain to bring down your score. The better your score is to begin with, the more it will drop.

A Chapter 7 bankruptcy remains on your credit report for 10 years from the date of filing; a Chapter 13 stays on the report for seven years. Accounts associated with a bankruptcy or debt settlement are removed from your report seven years after they initially become delinquent.

Bankruptcy laws regulate what happens to your money when your case is settled. Chapter 7 cases typically clear your debts, while Chapter 13 requires partial repayment. A bankruptcy judge will decide how much you need to repay based on laws in your state.

Debt settlement typically requires that you make a lump sum payment to clear your account. If you are unable to pay that amount right away (most people in default can’t), you’ll have to stop paying your credit card bills until you save enough to settle the debt. Stopping payment can further damage your credit and expose you to late fees, additional interest charges, collection efforts and lawsuits.

The possible advantage to settlement is that in exchange for a payment, creditors will sometimes agree not to report the settlement to the three major credit-rating bureaus. Your earlier credit problems probably have damaged you credit score, but if the settlement isn’t reported, it may take less time to rehabilitate your credit score.

Advantages and Disadvantages of Debt Settlement

Debt settlement can be the best way out of a financial mess, but it is full of pitfalls. The biggest problem is convincing a creditor, or multiple creditors, to accept less than they are owed. Creditors aren’t obligated to enter a settlement agreement, but many are willing if they believe you can’t pay and otherwise will file for bankruptcy protection – a step that could mean they receive little or nothing.

Some people hire a debt settlement firm to represent them, but others negotiate themselves. The advantage to contracting with a debt settlor is saving time and avoiding the hassle of negotiating yourself.

Advantages to settling a debt:

  • Pay a fraction of what you owe to become debt free.
  • Mitigate the long-term credit damage of bankruptcy to your ability to borrow money.
  • Negotiate with creditors and avoid the time and expense involved in bankruptcy.

Disadvantages to debt settlement:

  • Creditors might not want to negotiate with you.
  • When the creditors learn you can’t pay, they might file legal actions aimed at garnishing your wages.
  • Stopping payments to convince creditors that you are serious about not paying could result in your accounts going into collection, further damaging you credit as your debt increases.
  • If you settle a debt, state and federal tax collection will treat the forgiven amount as income and require you pay taxes on it.

Advantages and Disadvantages of Bankruptcy

Bankruptcy chapters 7 and 13 are the two avenues individuals have to clear their debts through the courts. Chapter 7 eliminates your debts, but in some states might require you to liquidate all you own, including your car and house, to help compensate your creditors.

Chapter 13 protects your home from foreclosure but requires that you partially repay creditors over a three- to five-year period. Because it requires repayment, it is often called “wage earner’s bankruptcy.”

Both chapters will cause long-lasting damage to your credit report. In addition, student loan debt, income taxes and child support payments can’t be discharged in bankruptcy, so you will still be obligated to repay them.

Advantages to Chapter 7 bankruptcy:

  • Clears most debts and offers a financial fresh start.
  • Doesn’t require the filer to pay taxes on unpaid debts.
  • Prevents creditors from pursuing collections.

Disadvantages to Chapter 7 bankruptcy:

  • Damages credit report for 10 years.
  • Some states allow seizure and sale of you home and other properties. You should review what is exempt in your state.
  • Requires that you wait eight years before filing again under Chapter 7.

Advantages to Chapter 13 bankruptcy:

  • Protects your property, including your house and car, from foreclosure and repossession to cover debts.
  • After you complete required payments, you receive a discharge of debt.
  • You aren’t required to pay taxes on forgiven debt.
  • Waiting period before you can file again is two years – six years less than under Chapter 7

Disadvantages to Chapter 13 bankruptcy:

  • Requires that you follow a court-ordered payment plan that lasts three to five years.
  • Reduces your credit score for years, making it difficult to borrow money or obtain credit.


NA, (2008, May). Debt Relief or Bankruptcy. Retrieved from:

NA, (2017, June 23). Debt Settlement vs. Bankruptcy – Which Option is Better? Retrieved from:

O’Shea, B. (2017, December 21). Debt Settlement: How It Works and the Risks You Face. Retrieved from:

NA, ND. How to Compare Debt Settlement vs. Bankruptcy: 14 Steps. Retrieved from:

About the author

Joey Johnston has more than 30 years of experience as a journalist with the Tampa Tribune and St. Petersburg Times. He has won a dozen national writing awards and his work has appeared in the New York Times, Washington Post, Sports Illustrated and People Magazine. He started writing for InCharge Debt Solutions in 2016.