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Is Debt Settlement Better or Worse Than Chapter 13 Bankruptcy?

by Louis DeNicola on
7/13/2022
in Repaying Debt
Woman reading financial documents.

The following is presented for informational purposes only and is not intended as legal advice.

Debt settlement (or debt resolution) and bankruptcy are two routes that some people choose to get out from overwhelming debt. Each offers its pros (and cons). But the goal is the same — get back on your financial feet.

How does debt settlement work?

If you’re already behind on your bills, you may be able to settle your debts with your creditors.

“In a debt settlement situation, the goal is to pay the creditor less than the entire amount and pay them over time interest-free,” says Leslie H. Tayne, Esq., a financial attorney and author of Life and Debt. “The debt settlement company or attorney is negotiating with them to settle the debt.” Alternatively, you may be able to negotiate your own settlements with your creditors.

A creditor may agree to take less than the full amount you owe because at least it’s getting something — particularly if you have an unsecured loan (such as credit card debt) and don’t owe so much that it’s worth the creditor’s time and money to sue you.

Generally, you’ll have to put money aside each month and build up a fund that you can use to settle your debts. You (or the company representing you) will then offer the creditor a payment plan that results in repaying less than what you currently owe.

How does Chapter 13 bankruptcy work?

There are two common types of consumer bankruptcy, Chapter 7 and Chapter 13.

A Chapter 7 bankruptcy (i.e., liquidation) could immediately wipe out your debts. However, you’ll need to qualify based on your income, and you’ll be forced to sell your non-exempt property.

A Chapter 13 bankruptcy may be a better option (and potentially your only option) depending on your income. With a Chapter 13 bankruptcy, you can:

  • Keep all your property
  • Catch up on payments and avoid foreclosure or repossessions
  • Make monthly payments for three to five years and then have your remaining debt discharged

There are still limitations on who can file a Chapter 13 bankruptcy, though. “You don’t get the right to file bankruptcy, you have to qualify for a Chapter 13, which means your income has to meet the means tests,” says Tayne. “ Then, you have to provide a proposed plan on how you’re going to pay back your creditors.”

When is debt settlement better than bankruptcy?

If you’re already behind on your bills (creditors are unlikely to accept less than the full amount owed if you’re current) and primarily have unsecured debts, and qualify (or can't afford) an option like a debt management plan, then debt settlement might be your best option.

You could benefit by repaying less money and may be able to set up a monthly payment plan for the settled amount. Tayne also points out that when you apply for insurance or financial accounts in the future, “they may ask if you’ve filed bankruptcy. But they generally won’t ask if you’ve settled debts.”

Debt settlement can also be more flexible if your financial situation changes. “In a bankruptcy situation, you have to report the changes back to the trustee, and that could alter your plan,” Tayne says. But with a debt settlement, you can stick to the same plan even if your income increases.

The drawbacks to debt settlement include potentially more severe consequences for a missed payment, including the creditor revoking the settlement agreement. “If you miss a payment, the creditor may be able to get the full amount you owed minus the amount you already paid,” says Shawn M. Yesner, Esq., owner of Yesner Law, PL. Missing a Chapter 13 bankruptcy plan payment could lead to your case being dismissed, but you may have a chance to catch up on your payments first. 

When is Chapter 13 bankruptcy better than debt settlement?

Chapter 13 may be a better option if you’re dealing with a foreclosure or vehicle repossession. You may lose your home or car while pursuing a settlement, but could be given the opportunity to catch up with a Chapter 13.

However, Chapter 13 can result in repaying more overall than debt settlement. You also won’t be able to file for a Chapter 7 bankruptcy during the next six years, will be on a payment plan for three to five years, and all your disposable income will be tied up the payments.

The bankruptcy may also have a larger negative impact on your creditworthiness as the bankruptcy can live on your credit reports for up to seven years after you file.

Ultimately, the best option comes down to your priorities and your unique situation. If you need help understanding which option makes the most sense for you, MMI offers free financial counseling 24/7, online and over the phone. 

Tagged in Debt settlement, Bankruptcy, Debt strategies

A corporate headshot of Louis DeNicola.

Louis DeNicola is a personal finance writer with a passion for sharing advice on credit and how to save money. In addition to being a contributing writer at MMI, you can find his work on Credit Karma, MSN Money, Cheapism, Business Insider, and Daily Finance.

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