If you’re researching bankruptcy or debt settlement (also called debt relief), you probably have overwhelming debt problems. Debt settlement and bankruptcy can both be effective solutions, but it’s crucial to make a choice that delivers the biggest benefit at the lowest cost.
Chapter 7, Chapter 13 and Debt Settlement Definitions
The debt relief vs. bankruptcy decision depends a lot on the type of bankruptcy you qualify to file.
What Is Chapter 7 Bankruptcy?
Chapter 7 is the liquidation or “clean slate” bankruptcy. With Chapter 7, you surrender “nonexempt” property to the court, and your unsecured debts are forgiven. You get to keep “exempt” property. What’s exempt or nonexempt depends on where you file.
— To be eligible for Chapter 7, you must pass a “means test.” If your income is below the median income in your state, you probably pass, but there are additional calculations.
— The bankruptcy court liquidates your nonexempt assets and turns over the proceeds to your unsecured creditors. Any remaining debt included in the bankruptcy is discharged, and you no longer owe it.
“It is widely accepted that bankruptcy is a last resort, for good reasons. In general, it could be a better option than debt resolution (settlement), when someone has no or few assets and overwhelming debt, or no income to repay some of their debt,” says Jason Pack, chief revenue officer at Freedom Debt Relief.
What Is Chapter 13 Bankruptcy?
Chapter 13 bankruptcy is often called the “wage earner’s bankruptcy.” With Chapter 13, you keep your property and pay your disposable income into a three- to five-year plan.
— You file your petition with the court and start making payments within 30 days. Meanwhile, the court is evaluating your proposed plan and may make changes.
— Each year, you submit copies of your tax returns to the court. When you complete your plan, your remaining unsecured balances are discharged.
Filing Chapter 13 also allows you to discharge some obligations that Chapter 7 does not — things like taxes, divorce obligations and property damage claims as well as fines, penalties and forfeitures, even if based on fraudulent conduct.
What Is Debt Settlement, aka Debt Relief?
Debt settlement is a private negotiation between you and your creditors. No law dictates how much you must pay or requires companies to negotiate with you.
— You or someone acting on your behalf contacts your unsecured creditors and offers a sum to clear your debt for less than what you owe.
— After you’ve paid the agreed-upon amount, the remaining balance is forgiven.
Debt settlement applies mainly to unsecured debt because secured creditors just repossess the collateral that you’ve pledged if you fail to repay them. If you have fallen behind on secured debt and you don’t want to lose your collateral, speak to a bankruptcy attorney. The automatic stay can give you time to negotiate with secured creditors, and Chapter 13 may be able to help you catch up on past-due amounts.
“Both bankruptcy and debt settlement have their place, and neither can be treated as a one-size-fits-all solution. In many cases, especially for those who qualify for Chapter 7, bankruptcy is the faster, cleaner and more certain route,” says Josh Richner, founder and senior advisor at FaithWorks Financial, a debt relief agency.
“That said, debt settlement can be a strong alternative. It is especially helpful for people who either can’t qualify for Chapter 7, would be forced into a burdensome Chapter 13 plan or who simply prefer to avoid the legal and emotional weight of bankruptcy.”
[SEE: Best Debt Settlement Companies]
Comparing Costs
When comparing the cost of bankruptcy vs. debt relief, you’ll look at three components: amount of debt you repay, cost of professional services and tax on forgiven debt. For this exercise, we’ll assume that you’ll hire a professional. However, people do successfully negotiate debt and a small percentage successfully DIY their bankruptcies (more common with Chapter 7).
Amount of Debt Repaid
With bankruptcy, the amount of debt that you repay is set by law and not up for negotiation. You must disclose all of your income, debts and assets when you file. With debt settlement, you’re not required to disclose anything, and you only pay if you reach an agreement.
— Most Chapter 7 bankruptcies are “no-asset” bankruptcies in which the filer surrenders no property at all.
— If you file Chapter 13, you’ll pay at least as much as you would if you filed Chapter 7. You can even be forced to repay 100% of the debt if you can afford to. That’s bad news if you have valuable nonexempt assets. Another factor is the amount of income left over after you cover necessities. If you have a lot of disposable income, expect to make higher Chapter 13 payments for up to five years. Those whose income is under the median generally get three-year plans.
— The amount you pay with debt settlement depends on what forgiveness you can negotiate. Forgiveness may be as much as 90% or as little as zero, but typically runs about 50% with professional debt settlement companies.
Cost of Professional Assistance
Fees for professional debt settlement vs. bankruptcy are generally calculated in completely different ways. Most personal bankruptcy filing fees and incidental charges are about $400.
Attorney fees range from $1,500 to $2,500 for Chapter 7 and $2,500 to $3,500 for Chapter 13. You generally have to pay Chapter 7 fees up front, but you can include Chapter 13 fees in your plan and pay monthly.
Debt settlement companies cannot legally charge fees until you pay the agreed amount to your creditor. But there may be account setup and monthly maintenance charges — about $10 to $30. The fee when you settle depends on where you live (some states regulate what can be charged) and the type and amount of debt settled. Typically, it runs between 15% and 25% of the account balance when you enroll it into a debt relief plan. Sometimes, the fee is calculated based on the amount saved or the balance at the time of settlement.
Taxes
Amounts discharged in bankruptcy are not generally taxable. Debts that are forgiven through a debt relief plan are taxable unless you’re insolvent, which means your debts exceed your assets. Debt forgiveness is nontaxable up to the amount of your insolvency.
For example, if the value of your assets totals $300,000, and your debts — including car payments, student loans, personal loans, credit card balances, mortgages and other financing — adds up to $325,000, you’d be insolvent by $25,000 and able to avoid federal income tax on up to $25,000 of debt settlement forgiveness.
[Read: Best Debt Consolidation Loans.]
When Bankruptcy Is Better
Here is an example in which bankruptcy is the less costly option.
The Smiths owe $40,000 in credit card debt and medical bills. They have no nonexempt assets, so they don’t have to surrender property. Attorney and filing fees would come to $2,400. Debt settlement fees are 25%. The family is insolvent, so forgiven amounts would not be taxed at the federal level.
[CHART]
When Debt Settlement Is Better
And here is an example of when debt settlement is cheaper.
The Youngs owe $40,000 in unsecured debt. Unfortunately, they don’t qualify to file Chapter 7, and they’d have to pay $600 a month into a Chapter 13 plan. Even with 25% settlement fees and a 25% tax bracket, it’s cheaper for them to settle their debt than to file bankruptcy. And if they’re insolvent, they’d save another $5,000.
[CHART]
[READ: 7 Steps to Paying Off Debt]
Bankruptcy or Debt Settlement? What Experts Say
Bankruptcy vs. debt settlement isn’t only about costs, but cost is often the most important factor. You can’t make an informed decision until you have the facts. Fortunately, it’s not hard to get them. Professional debt negotiators must analyze your situation for free. And the IRS has a worksheet to help you determine if you’re insolvent or not. It’s called Form 982.
Many bankruptcy attorneys offer free or low-cost consultations. They’ll estimate your fees and how much property you’d have to surrender (Chapter 7) or how much you’d pay into a plan (Chapter 13).
“To make the best decision,” says bankruptcy attorney Ashley Morgan of Ashley F. Morgan Law in Herndon, Virginia, “you need to know all your options. Talk to an attorney, look at the numbers. There are limited times I recommend debt settlement over Chapter 13.
“In some situations, Chapter 13 could be more expensive than debt settlement, especially if you have a lot of debt and a lot of nonexempt assets. If you cannot afford Chapter 13 because the required payment is more than your disposable income, it can make sense to try debt settlement at a lower amount.”
“During phone consults with people looking for the right method to tackle a debt problem, I often refer to Chapter 7 bankruptcy as the heavyweight champion of debt relief,” says Michael Bovee, founder and president at Consumer Recovery Network, a debt consulting firm. “Chapter 13 is the opposite. It is debilitating and inflexible. More than half the people who have filed chapter 13 in the U.S. have been unable to complete it.”
Pack says, “Bankruptcy may be a better route if a consumer has many credit accounts, and their total debt is so high and income is so low that it would take more than five years to complete a debt settlement program.”
Another advantage of bankruptcy is that creditor lawsuits are stopped (this is called an “automatic stay”) when you file.
“Some people have an unsecured creditor mix that can be viewed as highly aggressive. This could cause me to project that you would need to raise money faster than normal in order to settle certain accounts quickly,” says Bovee. “If that is not an option, you may want to consider Chapter 13 due to its ability to shield you from creditors taking you to court to try and collect.”
Morgan says, “I may recommend debt settlement when there are one or two debts at issue and you have other debts that you can continue to pay. Chapter 13 does not allow you to pick and choose debt, which means any credit card with a balance is closed. If you have five credit cards, but only one has a high balance and horrible interest, it could make sense to use debt settlement for one card and continue to pay the rest of the cards in the normal course. There can be a bit more flexibility with debt settlement than Chapter 13.”
Morgan also says that settlement might be better than Chapter 13 if you have joint debt with someone else who doesn’t want to file bankruptcy. “In Chapter 13,” Morgan says, “there is the co-debtor stay, which protects any joint debtors during the case for consumer debts. However, after the case is discharged, the balance will remain for anyone who didn’t file. If you have a joint debt with someone who is not your spouse, it may make more sense to settle the debt since you can settle the debt for all parties involved.”
More from U.S. News
How to Negotiate Debt Settlement Yourself
How Does Debt Settlement Work?
How to Avoid Paying Taxes on Debt Settlement
Debt Relief vs. Bankruptcy: Look Before You Leap originally appeared on usnews.com
