If you are looking for relief from your debts, you probably already know that you can follow one of two distinct paths: bankruptcy and non-bankruptcy. Before you decide which path to choose, you need to understand what your options are and the relative advantages of each. Let me first point out that it is always best to visit with an experienced bankruptcy attorney before making any major decision with respect to your debt. As a practicing bankruptcy attorney who owns a debt settlement company, I am highly experienced in helping people look at and compare their different options. I invite you to call me directly at 303-520-3414 to talk about the details of your particular situation so that I can go through the comparison with you. Below, I will outline some of the basic differences between these two debt-relief paths, but please understand that this is no substitute for a personal appointment with a qualified attorney.

Your options for getting out of debt without filing for bankruptcy include debt settlement, consumer credit counseling and, of course, simply paying off your debts over time. The non-bankruptcy option that I’ll be discussing here is debt settlement, also referred to as debt negotiation, debt resolution, and debt reduction. In brief, debt settlement involves reaching an agreement with your creditors to reduce the amount that they are willing to accept to settle your unsecured debts with them—potentially by as much as half of what you owe them. Another point of negotiation is the length of time over which the reduced amount can be paid; reaching a rapid lump-sum settlement can often result in an even greater reduction in what your creditors will accept to satisfy the debt. Debt settlement is generally completed in two years or less.

The two bankruptcy options generally available to individuals are Chapter 7 Bankruptcy and Chapter 13 bankruptcy. These names refer to the specific chapters of the U.S. Bankruptcy Code under which an individual can file bankruptcy. They are very different, so each deserves its own comparison to debt settlement.

Chapter 7 Bankruptcy vs. Debt Settlement

Chapter 7 bankruptcy and debt settlement are dramatically different solutions for getting out of debt and, generally speaking, are suitable for two dramatically different types of situations. Chapter 7 bankruptcy is a viable debt-relief option for people with limited income and few assets, whereas debt settlement is an option primarily for people who have higher income and some savings available for settling their debts.

To qualify for Chapter 7, the court requires an individual to pass what’s referred to as a “means test,” which has to do with the person’s ability (means) to pay off their debts. In most cases, your income must be at or below the state median income by family size for the state in which you live, and the value of your assets can’t exceed a pre-established threshold. It is sometimes possible to pass the means test if your income is a little above the median, but talk to your bankruptcy lawyer to find out whether you qualify.

You can see that these two options are essentially mutually exclusive. If you earn below the median income for your state, it’s likely that you do not have enough money for debt settlement to be a viable solution. Although in some rare instances an individual who qualifies for Chapter 7 bankruptcy is able to borrow money from a relative to settle his debts, I generally don’t recommend this, because owing friends and family often creates a whole new set of problems.

Chapter 13 Bankruptcy vs. Debt Settlement

Chapter 13 bankruptcy is usually referred to as a “debt adjustment” or “reorganization” bankruptcy. In a Chapter 13 case, you file a proposed budget and repayment plan with the court, showing how you will pay off some or all of your past-due and current debts over three to five years. The plan typically calls for only partial repayment of the debts. You are required to make monthly payments to the Chapter 13 Trustee assigned to your case, and those payments are then divided among your creditors according to the terms of the plan. Chapter 13 is generally suitable for individuals or couples who have high income, high debt or tax problems, or face foreclosure.

Unlike Chapter 7, Chapter 13 bankruptcy is often a solution that “competes” head to head with debt settlement, because both involve setting up a plan for repaying your creditors. Let’s look at Chapter 13 in more detail.

The pros and cons of filing Chapter 13 bankruptcy

Pros of filing Chapter 13 bankruptcy

The two biggest advantages of filing Chapter 13 bankruptcy are that your creditors are forced to accept the repayment plan you work out with the Chapter 13 Trustee, and you are typically not required to repay 100% of your debt. In fact, some plans call for payment of less than 10 cents on the dollar.

Cons of filing Chapter 13 bankruptcy

There are many downsides to a Chapter 13 bankruptcy. The primary disadvantage is that you have to propose a repayment plan and a budget to the Chapter 13 Trustee, justifying what you will spend your money on each month. At your hearing, the Trustee (and often your creditors’ attorneys) will scrutinize your budget and require you to cut it even more. For instance, if your Trustee is strict, she may require that you eliminate dining out. Chapter 13 Trustees typically give people very little breathing room in their budgets and repayment plans, so if you were to have an emergency expenditure, you could easily get behind on your monthly Chapter 13 payment. What happens to many people in those instances is that their Chapter 13 cases get dismissed and they get thrown back to the wolves—their creditors. Then they have a bankruptcy notation on their credit reports, without having any of their debts discharged or getting any bankruptcy protection! The last time we checked, the percentage of Chapter 13 filers who successfully completed their repayment plans was less than 40%. Another disadvantage of filing a Chapter 13 bankruptcy is that you must include all of your credit cards; you cannot leave out one or two for convenience purposes, such as for making airline or hotel reservations.

The optimal candidate for Chapter 13 bankruptcy

Chapter 13 bankruptcy may be the best solution for you if:

• You own your home and are in danger of losing it to foreclosure, but you could get caught up on your payments if given time.
• You are behind in your automobile payments but could catch up if given time.
• You have valuable non-exempt property that you would like to retain, and you can afford to pay creditors from your income over time.
• You have debts that are dischargeable under Chapter 13 but not Chapter 7 (for instance, debt incurred as a result of fraud).
• You owe the IRS or the state for back taxes.

Deciding between Chapter 13 and debt settlement

With these differences in mind, here are some factors to consider when you are comparing the relative benefits of Chapter 13 bankruptcy and debt settlement:

• First, you want to know what your repayment percentage will be in a Chapter 13 plan, because this can vary wildly. If your plan calls for a 20% repayment, it would almost certainly be cheaper for you than debt settlement, which typically involves repayment of 50–60% of your debt. On the other hand, if your Chapter 13 repayment plan calls for 100% repayment of your debts, then debt settlement would be a cheaper way to go.How do you know how much of your debt you’ll have to repay in a Chapter 13 bankruptcy? You need to consult an attorney experienced in Chapter 13 bankruptcy in your state to get an informed estimate, but your payment amount is basically calculated by taking your net income and subtracting your “reasonable and necessary monthly living expenses” (not counting credit card payments and other unsecured debt payments). So the more money you make, the higher your payment percentage is going to be.
• Second, ask yourself whether any of the special circumstances that Chapter 13 was designed to handle—tax debt, foreclosure or fraud—apply to you. If that’s the case, Chapter 13 is likely to be your best bet.
• A third factor to consider is the relative effect on your credit rating. Both debt settlement and Chapter 13 bankruptcy will do a number on your credit rating, but the time it takes to bounce back can differ. In my experience, I have seen clients’ credit ratings go back up within a year and a half after completing a debt settlement plan (which is usually done in less than two years). Under Chapter 13, you cannot get any credit for the duration of the plan, which is typically five years. Once you have completed your repayment under Chapter 13, it shouldn’t take more than a year before your credit rating bounces back to a reasonable level. This factor usually tips the scales in favor of debt settlement.
• With Chapter 13 bankruptcy you have court involvement, which is not the case with debt settlement. This means that 1) the court decides what you must pay each month; 2) you may have to justify what you spend your money on each month; 3) the court stays involved in your affairs for the duration of the plan, usually three to five years; and 4) your bankruptcy becomes public record.
  On the other hand, court involvement also means court protection, so not only are your creditors required to accept the payment plan dictated by the court, they are also prohibited from continuing their debt collection efforts or bringing suit against you. Debt settlement provides no such protection. This is why it is critical to shorten the time frame of a debt settlement plan to no more than 24 months. In my experience, if debt settlement is completed within 24 months by a qualified debt negotiator, it works very well for most clients. On the other hand, if your debt settlement plan is of the three-to-five-year variety, your chances of being sued by any or all of your creditors increase dramatically, and you’ll probably be forced into bankruptcy despite your efforts to avoid it.
• The difference between the tax consequences of debt settlement and Chapter 13 bankruptcy is also something to consider, and is covered in a separate article on this site (click here to read it). I recommend that you read that article and then consult a CPA to discuss your specific situation and the potential tax consequences of your actions.

Conclusion

As you can see, there are a number of factors to consider when comparing debt settlement to bankruptcy. Please feel free to contact me if you would like a consultation regarding the relative pros and cons in your specific case. It is often said that “a wise man gathers much counsel,” and it could not be more true when dealing with your financial future.

 

Steve Craig is an experienced bankruptcy and debt-settlement attorney based in Denver, Colorado.