Millions of Americans are carrying more debt than they can possibly pay, often as a result of medical issues, job loss, or other factors beyond their control. Debt settlement and bankruptcy are common solutions.

Debt settlement is heavily promoted – often by people who are in the debt settlement business – but if you qualify for Chapter 7 bankruptcy, it is almost always the better option if you truly have no way to pay your debts.

Let’s examine these two options, their pros and cons, and the reasons for that conclusion.

Debt Settlement vs. Bankruptcy: What’s the Difference?

Both debt settlement and bankruptcy can reduce the amount you owe. That places them among the top options for people who owe more than they can possibly pay.

Debt settlement and bankruptcy accomplish that goal in very different ways. Before we start looking at the advantages and disadvantages, let’s look at how the two methods work.

Both bankruptcy and debt settlement address unsecured debts, like credit card debt, medical debt, personal loans and payday loans. Secured debts, like mortgages and car loans, will not be included, but resolving your unsecured debts can make it easier to pay your secured debts.

How Debt Settlement Works

Debt Settlement involves negotiating with creditors to accept less than what you owe as full payment of a debt. You will typically offer a single lump-sum payment to resolve the debt.

Of course, they won’t just roll over and accept any settlement you offer. They want to get paid in full. You will have to negotiate effectively. There is no guarantee that a creditor will be willing to negotiate.

The Obstacle

Debt settlement typically requires a lump sum payment. Creditors may accept much less than what you owe, but it can still be a substantial amount of money, especially if you have multiple creditors. Most people with serious debt problems don’t have that kind of cash available.

Debt settlement companies will typically ask you to stop making debt payments and pay into a  debt settlement account instead. When you have accumulated enough money, they will commence negotiations.

Many debt settlement companies are sketchy, and some operate illegally (by charging upfront fees, for example). If you decide on debt settlement, choose a reputable debt settlement company.

Debt Settlement by the Numbers

The American Fair Credit Council, the trade association for debt settlement companies, offers these facts and figures to help us understand the industry better.

• Debt settlement companies cannot charge up-front fees. They charge a percentage of the amount of your debt that is forgiven.
• The typical client owes over $25,000 in unsecured debt.
• Debt settlement saves an average of $2.64 for every dollar paid in fees.
• The average consumer who completes a debt settlement program reduces their original debt loan by 30% after fees.
• Fees typically range from 15% to 25% of the amount forgiven.
• Customers typically see initial settlements within four to six months.

The National Foundation for Credit Counseling (NFCC) states that it typically takes two to four years to complete a debt settlement program, largely because of the time it takes to save enough money to offer credible settlements^[1].

The Federal Trade Commission (FTC) states that the average completion rate for debt settlement programs is 45% to 50%^[2].

How Bankruptcy Works

Bankruptcy is very different. It is a legal procedure carried out by federal bankruptcy courts. Courts follow the same rules nationwide, and their decisions are legally enforceable.

Bankruptcy is designed to give people who can’t pay their debts a fresh start, which can include the complete discharge, or elimination, of unsecured debts. 

There are many types of bankruptcy, but almost all individual bankruptcies fall into these two:

• Chapter 7 bankruptcy is designed for lower-income people who have no way to pay debts. The court can seize personal assets and use the proceeds to pay creditors, but in practice, this is rare. 
• Chapter 13 bankruptcy is for people who have enough income to pay some or all of their debts. Your assets will not be seized, but the court will order a payment plan which may take several years to complete. At the end of the plan, the remaining debts may be discharged.

If your income is below the median income for your state, you qualify for Chapter 7 bankruptcy. Above the median, you can qualify by passing a means test. If the means test determines that you have the capacity to pay some debt, you will have to use Chapter 13.

Learn more: Chapter 7 vs. Chapter 13 Bankruptcy: 12 Differences You Need to Know.

The Obstacle

Bankruptcy is a complex process that involves significant effort and costs. The required forms are complex. The filing fees are significant, and the prospect of going to court can be intimidating.

Most people who file for bankruptcy will hire an attorney. A lawyer will greatly increase your chances of a successful filing but will also add substantial costs.

If you’re filing a simple Chapter 7 bankruptcy, you have a cheaper option. Upsolve, an app billed as “TurboTax for bankruptcy”, will generate all of your bankruptcy forms and walk you through the process for free.

Bankruptcy by the Numbers

• Around 60% of personal bankruptcy filings are under Chapter 7, with around 40% under Chapter 13.
• 96% of Chapter 7 bankruptcies close with no assets being liquidated^[3].
• Only around 1% of Chapter 7 bankruptcy petitions are dismissed. 99% of Chapter 7 filings get a discharge of all or some unsecured debt.
• A Chapter 7 bankruptcy typically takes four to six months to complete.
• The court filing fee for a Chapter 7 bankruptcy is $338. Credit counseling courses, printing, and other costs will add to that.
• Attorney’s fees for a typical Chapter 7 bankruptcy average around $1500. This may vary with your location, the complexity of your case, and other factors.

Most individual bankruptcies are Chapter 7 since most people with serious debt problems have incomes below their state’s median.

Debt Settlement vs. Chapter 7 Bankruptcy

If you have debts that you can’t possibly pay, which of these methods is best for you? Let’s do a head-to-head comparison and find out. We’ll stick to comparing debt settlement using a debt settlement company to Chapter 7 bankruptcy.

What Type of Process is Used?

Debt settlement involves a purely voluntary arrangement between a debtor and a creditor. The creditor has no obligation to negotiate or to agree to a settlement.

Bankruptcy is a legal process. A creditor can challenge a discharge in court (this rarely happens), but the judge’s decision is final. If a bankruptcy court discharges a debt, it’s gone. You have no further obligation to pay it.

How Long Does It Take?

Debt settlement requires cash settlements. If you have the cash, you can offer these immediately, but if you have the cash, you won’t need to settle. Most debt settlement company customers take two to four years to complete the program.

Chapter 7 bankruptcy typically takes four to six months to complete, from filing to discharge. 

What is the Minimum Amount of Debt?

Debt settlement companies have a minimum amount of unsecured debt that they require. This is often $10,000, but some companies have a $7500 minimum. 

Chapter 7 bankruptcy has no minimum debt requirement for filing.

How Much Debt Will Be Eliminated?

Debt settlement companies report that customers typically reduce their debt load by 30% once company fees are factored in. If you enter the program with $10,000 in unsecured debt, you will still pay $7000.

Chapter 7 bankruptcy typically discharges 100% of the outstanding unsecured debts.

Can Your Creditors Still Pursue You?

Debt settlement companies typically ask you to stop paying creditors and pay into a debt settlement account instead. When you stop making payments, your creditors will come after you. Accounts may be charged off and sent to collectors, who will contact you.

The Federal Trade Commission (FTC) reports that an average of 7% of debt settlement customers are sued by a creditor during the process^[3].

Bankruptcy courts issue a stay on collection efforts as soon as a filing is made. Creditors are not allowed to contact you, and all foreclosure or repossession proceedings stop.

How Much Does it Cost?

Debt settlement companies typically charge 15% to 25% of the debt forgiveness they negotiate. So if you have $10,000 in unsecured debts and the company negotiates them down to $5000, your fee will be between $750 and $1250, and you will still have $5000 to pay.

Chapter 7 bankruptcy fees for filing, debtor education classes, copying and other costs will usually be under $500. Fees may be waived if you are under high financial stress. The average attorney fee is around $1500. 

Your cost will be around $2000 if you use an attorney, regardless of the amount of debt involved. If you have a simple case and you choose to use Upsolve instead of hiring a lawyer, your costs could be under $500 or lower if you can get a fee waiver.

How Much of That Cost Is Upfront?

Debt settlement companies are not allowed to charge upfront fees. They can only charge when settlements are successfully negotiated.

Bankruptcy fees and legal costs are typically paid upfront, though you may be able to negotiate an installment plan.

What is the Success Rate?

Debt settlement companies report completion rates of 35% to 60%, according to the FTC, with the average around 45% to 50%. Failures are usually because the debtor is unable to save enough to offer settlements.

Chapter 7 bankruptcy sees around 1% of filings dismissed. 99% of filings result in the discharge of some or all unsecured debts.

What Will Happen to My Credit?

Debt settlement will damage your credit. When you stop making payments to save for a settlement, late payments will be recorded. Accounts may be charged off and sent to collections. All of these will become derogatory records on your credit report.

If your creditors accept settlements, the debts will be marked as settled for less than the amount owed, which will also damage your credit. All of these records will remain on your credit report for seven years from the date of the original delinquency.

Bankruptcy will do severe damage to your credit score. A Chapter 7 bankruptcy can remain on your credit score for ten years.

What Are the Risks?

Debt settlement has several risks to consider. Some creditors may not be willing to accept a settlement, leaving you with damaged credit and no debt reduction. You may not be able to save enough to offer settlements.

It’s important to be very careful when selecting a debt settlement company. Not all players in the industry are reputable.

Bankruptcy also has risks. A bankruptcy court can seize your assets and sell them to pay creditors. This is rare in practice – only 4% of Chapter 7 bankruptcies involve asset seizures – but it happens.

If your paperwork is flawed, your case may be dismissed, and you’ll forfeit your deposit. You must be absolutely accurate when reporting your income and assets. Some creditors could challenge the discharge of their debts.

So What’s Better?

Here’s an opinion: for most people who qualify for a simple Chapter 7 bankruptcy with no assets at risk, bankruptcy is a better choice than debt settlement. That may be a controversial opinion – bankruptcy is usually considered a last resort – but there are reasons.

You’ll Lose More Debt

Debt settlement will typically reduce your debt load by 30%, including debt settlement company fees. That leaves you with 70% to pay. Bankruptcy can and often does discharge 100% of your unsecured debts.

No More Harassment

When you file for bankruptcy, a stay is issued on all collection efforts. This is not optional: collectors must stop contacting you, and foreclosure or repossession efforts must stop.

Debt settlement usually involves stopping all payments while you save enough to offer lump-sum settlements. You can expect to face accelerated collection efforts when you stop payments. Accounts may go to collection agencies, and you could even be sued.

It’s Over Faster

A bankruptcy court isn’t fun, but neither is dodging creditors while you try to funnel money into a debt settlement account. Completing a debt settlement program takes two to four years. A Chapter 7 bankruptcy takes four to six months.

You’re More Likely to Succeed

45% to 50% of the people who start debt settlement programs fail to complete them. 99% of Chapter 7 bankruptcies end with the discharge of debts.

It’s Cheaper

When you combine the company fees with the remaining debt you’ll need to pay, debt settlement will almost always leave you putting out more money than a Chapter 7 bankruptcy, especially if you use Upsolve to generate your bankruptcy forms.

One plus point for debt settlement is that the cost is typically spread out over more time.

It’s Legal

Debt is a legal contract. When you stop making payments to put money into a settlement fund, you are violating that contract, which can have legal consequences. Bankruptcy is a legal process from the start.

When you deal with a debt settlement company, you are dealing with a for-profit company that has a vested interest in selling its services. A bankruptcy court may be complex and bureaucratic, but they won’t try to sell you on bankruptcy.

But What About My Credit?

A Chapter 7 bankruptcy will remain on your credit report for ten years. This is often seen as a downside of bankruptcy, and it is something to consider. It is also often overrated as a factor. Here are some points to consider.

• Your starting point. Most people who are choosing between debt settlement and bankruptcy have badly damaged credit already. If your credit score is already shot, there’s less damage that either can do.
• Both options will hurt. Both bankruptcy and debt settlement will hammer your credit.
• Recovery matters. What you do after your recovery from a debt crisis has more impact on your creditworthiness than what you do during it. Discharging all of your unsecured debt will allow you to recover faster than settling 30% of it.

Remember that the impact of a negative record on your credit report – no matter what that record is – declines with time. Creditors and scoring models want to know how you’re handling money now, not how you handled it five years ago.

If you pay all your bills on time, keep your credit utilization down, and generally handle your money well, your credit will recover long before the negative records from either bankruptcy or debt settlement drop off your record.

It’s Up To You

Debt settlement and bankruptcy are both valid methods of resolving debts. Both have been used by millions of people with severe debt problems.

As with any financial decision, the best choice for you is the one that best suits your unique needs and situation. To decide what that is, you’ll need to block out promotional efforts from people who are trying to sell you their services and focus on the pros and cons of the options in front of you.

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