Editorial Policy

Deciding between bankruptcy and debt settlement

Erica Sandberg

September 24, 2013

QDear Erica,

Would it be better to do a bankruptcy to get rid of $20,000 in credit card debt once and for all? Or should I do four settlements at a fraction of the cost in a period of four years to clear the debt? — Pascale

AHi Pascale,

The question is, better for whom and what?

It might be better for your bank account if you were to escape paying what you borrowed, but it would be worse for your credit rating. The lender, meanwhile, would prefer that you uphold your end of the bargain and send them what's due. And if you do that, your credit rating would benefit as well.Ask Erica

Therefore, how to best handle your situation depends on the current and future state of your financial circumstances. It also depends greatly on your assets. That includes cash that's coming in as income and what you have in the bank in non-retirement savings.

Here are the best courses of action based on a variety of plausible economic scenarios:

  1. You have no assets now, and never will. If you have absolutely nothing with which to repay your debts and do not expect conditions to improve in the next year or two, then bankruptcy may be right for you. You'll have to choose between a Chapter 7 and a Chapter 13 bankruptcy, and the one that's best for you will depend on your income. However, another possibility is simply doing nothing. You may be judgment proof, which means that even if the creditors sued you for the debts and won the case, they couldn't take anything from you — because you have nothing to take.
  2. You have no assets now, but will later. Perhaps your downturn is only temporary and you'll be back on your feet soon. In that case, contact those you owe and let them know that you can make good on your agreement when you're earning more, or offer to pay in installments. Some creditors will wait. Contact them, explain what is happening and try to work out an agreement. If they say, “Too bad, we're going to sue you,” then you can consider discharging your balances in bankruptcy court.
  3. You have assets now, but not much. This is where debt settlements come in. A debt settlement means the creditor has agreed to let you pay less than you owe. Collection agencies are far more likely to accept a settlement than original creditors are, but it's always worth a shot. Know what you can afford to send as a lump sum payment to each entity you owe, then contact them and start the negotiation process. Most will want the bargained-down sum in a single payment (over a four-year stretch is almost unheard of), but maybe they'll be OK with a couple of installments. You won't know until you try. Be aware, though, that any forgiven amount over $600 is considered income, so you may see a higher than expected tax bill this year.
  4. You have assets and enough to get by and meet your bills. The answer for this scenario is obvious: Pay what you owe. Don't futz around and try to get away with something. If you've got the funds, there is no reason to declare bankruptcy. Sure, you may be able to score a settlement, but paying in full is almost always the best way to go. It's not only better for your credit reports and scores (bankruptcies and settlements will both drag your credit scores down), but you can be proud that you did the right thing. I strongly recommend going to a credit counseling agency, as a counselor can help you design a livable budget while also helping you delete your balances within the three- to five-year time frame you desire.

I wish you the best of luck with making the right decision!

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