Bankruptcy vs. Debt Relief

Debt relief vs. bankruptcy is on a lot of our minds these days. Not without reason. Some of us are in big financial trouble.

U.S. households owe $17.8 trillion in debt, and we’re having trouble keeping up: 3.2% of all outstanding debt is in some stage of delinquency, the Fed says.

We’re maxed out, and we’re falling behind.

“When you’re struggling to make ends meet because of a mountain of debt, you do have options,” says financial advisor Scott Lieberman, founder of TouchDownMoney.com. “Neither is a great short-term choice, but both debt relief and bankruptcy can help you move forward and remove some of your past financial issues.”

Debt relief and bankruptcy both offer solutions to the same problem — finding the most direct road out of debt — and they each carry advantages and disadvantages. Choosing the right one is tricky.

What Is Bankruptcy?

Bankruptcy helps people (or businesses) who cannot pay their debts get a fresh financial start, either by forgiving their debts or by setting up a manageable repayment plan.

Individual bankruptcies typically fall under two categories.

Chapter 7 bankruptcy, often called “straight bankruptcy” or “liquidation bankruptcy” is the most straightforward, allowing consumers to shed certain unsecured debts, such as credit card balances and medical bills. Sometimes Chapter 7 involves selling off qualifying high-value assets (coin or stamp collections; second homes; investments such as stocks or bonds) to at least partly pay back creditors.

“Chapter 7 bankruptcy is often the best choice if you have few assets and a lot of unsecured debts, like hospital bills or credit cards,” says Mark Hirsch, a personal injury lawyer at Temper & Hirsch in Aventura, Fla. “The process doesn’t take long — usually three to six months— and can eliminate most of your bills, giving you a fresh start.

“After filing, I’ve seen people get back in charge of their lives, but it’s essential to know that you could lose assets that aren’t … exempt.”

In Chapter 13 bankruptcy, filers who earn too much money to qualify for Chapter 7 have their debt loads reorganized under a court-supervised payment plan that can last three-to-five years. At the end of the payment plan, whatever balances remain (if any) are dismissed.

“You should go with Chapter 13 if you have a steady income and want to keep essential things like your home,” Hirsch says. “I’ve helped many people who chose Chapter 13 to keep their homes and avoid eviction. They found it easy to catch up on their debts while keeping their homes.”

Advantages and Disadvantages of Bankruptcy

Chapters 7 and 13 are the two avenues individuals can use to legally clear their debts through bankruptcy courts. Chapter 7 eliminates your debts, but in some states and under certain circumstances, it might require you to liquidate all you own, including your car and house, to help compensate your creditors. (Do not panic: These cases are rare; the vast majority of Chapter 7 filings go through as no-asset cases, in which all the individual’s personal property is exempt.)

Chapter 13 protects your home from foreclosure but requires at least partially repaying creditors over that aforementioned three-to-five year period. Because it requires repayment, Chapter 13 often is called “wage-earner’s bankruptcy.”

Both chapters cause severe and prolonged (up to 10 years) damage to your credit report. In addition, certain obligations, such as student loan debt, income taxes and child support payments, can’t be discharged in bankruptcy. Consumers remain on the hook for those debts.

Advantages to Chapter 7 Bankruptcy:

• Clears most debts and offers a financial fresh start.
• Doesn’t require the filer to pay taxes on unpaid debts.
• Prevents creditors from pursuing collections.
• Can be resolved in six-to-eight months.
• Typically, most (if not all) assets are protected from liquidation.

Disadvantages to Chapter 7 Bankruptcy:

• Damages credit report for 10 years.
• Some states allow seizure and sale of your home and other properties. You should review what is exempt in your state.
• Requires a means assessment.
• Requires waiting eight years before filing again under Chapter 7.

Advantages to Chapter 13 Bankruptcy:

• Protects your property, including your house and car, from foreclosure and repossession to cover debts.
• As in Chapter 7, filing immediately stops creditors from continuing collections activities.
• After required payments are completed, remaining debt balances are discharged.
• You aren’t required to pay taxes on forgiven debt.
• Waiting period before you can file again is two years – six years fewer than under Chapter 7

Disadvantages to Chapter 13 Bankruptcy:

• Requires following a court-ordered payment plan lasting three-to-five years.
• Reduces your credit score for years, making it difficult to borrow money or obtain credit.

What Is Debt Relief?

Debt relief is an umbrella term that covers an assortment of methods for conquering suffocating debt. These include debt settlement, debt management plans, and debt consolidation loans.

While significantly different in their approaches, each strategy is designed to make your debt less formidable, either by reducing the amount owed or by making payments more manageable (via negotiation with creditors, or a low-interest personal loan).

Advantages and Disadvantages of Debt Relief

As with bankruptcy, debt relief comes with benefits and liabilities. Done right, individuals can see their debt balances, interest rates, and even their monthly payments shrink. Even then, however, alert consumers must watch out for steep fees, creditors who won’t play ball, potential lawsuits, and damage to their credit scores.

It’s always something, right?

Advantages to Debt Relief

Debt relief has its upsides, among them:

• Reduction in total debt (debt settlement).
• Lower interest rates (debt management, debt consolidation loan).
• A single monthly payment lower than the combination of your current minimum payments (debt management, debt consolidation loan).
• A date certain when your debt will be paid off (debt management, debt consolidation loan).
• Avoiding the hassle and stigma of bankruptcy, while maintaining a certain amount of flexibility not available under court-directed resolutions.

Disadvantages to Debt Relief

• Significant fees may apply, particularly for consumers using debt-settlement companies.
• Negative impact on the consumer’s credit score. Debt settlement causes the worst harm; debt management results in an immediate dip, which begins turning around early in the payment plan; applying for a debt consolidation loan creates a hard inquiry that can cost you 10 points.
• Creditors who do not agree to terms of a debt settlement proposal may sue the consumer.
• Because the IRS considers forgiven debt balances as income (debt settlement), you may owe income tax.

Key Differences Between Debt Relief & Bankruptcy

While debt relief and bankruptcy both offer ways to manage crushing debt, there are significant differences. For openers, debt relief is conducted privately; bankruptcy involves the court system, and all its official functions are open to public inspection.

Other considerations regarding bankruptcy include having to pay filing fees, court costs, and — to ensure the best possible outcome — an attorney.

Chapter 7 bankruptcy is the swiftest, surest method to wiping out your debt and getting you on the road to financial recovery in the shortest amount of time. But it also guarantees the worst damage to your credit score. Chapter 13 is only slightly less harmful. And both linger on your credit report for up to 10 years.

By comparison, debt relief can be slightly more complicated; also, because it involves a commitment from the debtor to follow a plan without the force of law behind it, it’s more likely that a debt relief plan can go astray.

However, successfully executed, debt relief plans can achieve the same result as bankruptcy — debt subdued in the short term and eliminated down the road — with less long-term impact.

Again, it depends on your chosen strategy. Debt settlement comes with eye-popping fees (up to 25% of the initial debt) and no guarantees that the creditors will accept a haircut. Your case also can take quite a while to resolve, as long as five years. After that, reports of settled balances cling to your credit report for seven years.

Debt settlement might be a good fit if you are struggling mightily to make ends meet; you’re way behind — 120 days or more — or have been contacted by collection agencies; and you’re in financial hardship.

Debt management, especially if directed by a nonprofit credit counseling agency, usually takes between three and five years to resolve. A small agency fee of up to $75 per month is included in the single monthly payment distributed among your creditors who are part of the plan.

Again, entering a debt management plan will have an impact on your credit score, but it should recover as you make on-time payments and lower your overall debt.

Finally, a debt consolidation loan — if your credit score hasn’t already gone too far south to score a competitive rate — can put you on the road to recovery with minimal fuss and cost. But beware of the temptation to begin charging again once your balances are swept into the consolidation loan.

Whatever you do, be careful going forward, says Christine Moriarty, a Bristol, Vt.-based certified financial planner and personal coach. Be aware of those factors that got you into your financial predicament in the first place, she says, so you can avoid an unhappy repeat.

“Debt is more than a financial issue,” Moriarty says. “This is an emotional issue. People have a range of issues — addiction, cultural training, poor planning skills, self-sabotage.

“They also like quick fixes which got them into this situation in the first place…. Yet, there is a bigger issue including lack of planning and typically living in reality.”

When to Consider Debt Relief or Bankruptcy

Choosing between debt relief and bankruptcy can be challenging. But this is no time for going with your gut or flipping a coin. Understanding the key factors will help you choose wisely.

• Amount of debt: Bankruptcy should be your last refuge, chosen only if your debt outstrips your ability ever to repay it.
• Income level: Consumers who have sufficient income may find debt relief to be superior — more effective, more efficient — to bankruptcy; keep in mind, only debtors with comparatively little income qualify for Chapter 7.
• Type of debt: Bankruptcy alleviates financial pain linked to certain unsecured debts: credit cards, personal loans, medical bills. If you’re weighed down by student loans, back taxes, and/or child support payments, bankruptcy won’t help. Similarly, bankruptcy is a nonstarter if secured assets — too much house, an over-expensive car payment, a penchant for borrowing to shop at Tiffany & Co. — are the source of your financial troubles.
• Long term financial goals: Even in those moments when debt takes your breath away, your choices should be at least in part guided by your goals and hopes. Any number of big life goals, including buying a house and starting a family, will be weighed down by a bankruptcy on your record.
• Privacy: If keeping your financial vexations to yourself is important, avoid bankruptcy, which is a matter of public record. Debt relief is between you and your creditors.

Debt Relief vs. Bankruptcy: Which Is Better?

When it comes to choosing between debt relief and bankruptcy, the correct answer to the question posed above — Which is better? — is, possibly, unsatisfactory. Nonetheless, here it is: Which is better? It depends.

Nobody really, truly wants “one-size-fits-all” jeans, which can be too snug or too saggy in all the wrong places. The same applies to prickly financial situations. You want the solution that best fits your individual circumstances.

What’ll it be? Debt consolidation? Debt management? Debt settlement? Bankruptcy?

If weighing the factors above has brought you no closer to a resolution, it may be time to enlist a professional. Initial consultations with financial advisors or bankruptcy attorneys are often free and without obligation. The same holds a financial review with a certified counselor at a nonprofit credit counseling agency.

Hirsch, the Aventura personal injury attorney, is on board with the consultation angle.

“Your financial situation will determine whether you should file for bankruptcy or get debt help,” he says. “If you’re about to lose your home or have your wages garnished, bankruptcy might be the only way out.

“Debt assistance might be a better option if you want to avoid bankruptcy and can stick to a payment plan. It would be best to talk to a good lawyer about your situation to make the best choice.”

For her part, Moriarty recommends a certified credit counselor who charges no more than $100 for an initial consultation. “Too many ‘professionals’ are out to make money on a panicked debtor,” she says. “This backfires in the long run without a plan.”

The fact that you are committed to taking command of your debt is a vital first step. Now, review your options. Maybe recruit some expert assistance. Do all you can to give yourself the best shot at success.