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Should I Do Debt Settlement or Bankruptcy?

Jar with a sign saying "debt settlement"

What is Debt Settlement

Debt settlement is a type of debt relief that involves negotiating with creditors to pay a reduced amount of money to fully settle the debt. Debt settlement is typically used for unsecured debts like credit card debt, medical bills, and personal loans. You can attempt debt settlement on your own or hire a debt settlement company to take care of the process for you.

Debt settlement differs from a debt management plan or credit counseling, which involve working with a credit counseling agency to create a repayment plan and negotiate lower interest rates with creditors. Debt consolidation, on the other hand, involves taking out a new loan to pay off multiple debts, combining them into a single monthly payment.

How Debt Settlement Works

The first step of any debt settlement process is allowing yourself to default on all of the debts you want to negotiate. Otherwise, your creditors will never agree to accept a reduced amount if you're current on your payments. If you're working with a debt settlement company, the next step is agreeing to a payment plan for you to make monthly payments to them over a period of time. They'll save this money until they believe they have enough to make a lump sum offer to a creditor. Sometimes one lump sum payment is enough to fully settle a debt and other times a settlement may require an initial lump sum with some additional monthly payments until the agreed amount is paid. After the agreed amount is paid the creditor updates the account status on your credit report to "settled."

What You Should Know Before Choosing Debt Settlement

Man sitting at his computer looking at a letter, he looks defeated

Before choosing debt settlement as a debt relief option, there are several important factors to consider:

  • Risk of getting sued: Creditors aren't required to agree to a settlement just because you or a company you've hired is attempting to negotiate. We regularly meet folks who were participating in debt settlement when they got sued by a creditor, and most of the time these folks had no reason to suspect that they should be concerned about how the negotiations were going.

  • Risk of increased debt: Some creditors may not sue you even though they refuse to agree to a settlement. We've seen folks in this situation who "complete" their debt settlement program only to discover that one or more of their creditors never agreed and the balance owed has skyrocketed above their original debt due to late fees and interest.

  • Tax consequences: The amount of debt forgiven through debt settlement is considered taxable income by the IRS. Each creditor who agrees to settle with you for a reduced amount will send you a 1099 at the end of the year and you'll have to report the forgiven amount as income when you file taxes, which means that you'll end up paying taxes on the amount of debt that's forgiven. This often results in owing the IRS and comes as a huge surprise to many folks who choose debt settlement.

  • Impact on credit report: Debt settlement has a negative impact on your credit score for two reasons. First, you must miss payments and allow your account to go into default before the creditor will negotiate. Each missed payment that's reported to the credit bureaus can hurt your credit score will stay on your consumer credit report for seven years. The second reason why debt settlement can negatively impact your credit is due to the account status "settled." This account status indicates that you didn't pay the entire amount owed and can impact your credit and be a red flag to lenders in the future.

  • Negative impact on future borrowing: Debt settlement can make it more difficult to obtain credit in the future. Lenders may view a history of debt settlement as a sign of financial instability and may be hesitant to extend credit or offer favorable terms.

  • Suitable for unsecured debt: Debt settlement is typically used for unsecured debts, such as credit card debt and medical bills. It may not be suitable for secured debts, such as auto loans or mortgages. Additionally, it's not going to help with child support or student loan debt.

What the Consumer Financial Protection Bureau Says About Debt Settlement

The Consumer Financial Protection Bureau (CFPB) is a government agency charged with protecting consumers from unfair and deceptive financial practices. Here's a quote from the opening paragraph of one of the CFPB's articles on debt settlement companies:

"Debt relief or settlement companies are companies that say they can renegotiate, settle, or in some way change the terms of a person's debt to a creditor or debt collector. Dealing with these companies can be risky."

The article goes on to warn that "Debt settlement may well leave you deeper in debt than you were when you started."

Exploring Bankruptcy as an Option

If you're exploring debt relief options then you need to make sure to consider personal bankruptcy. Bankruptcy is a legal process that completely eliminates certain debts and can restructure others, and it's almost always the fastest, cheapest, and least risky way to get out of debt.

Overview of Bankruptcy

Bankruptcy is a legal process that takes place in a special bankruptcy court and involves bankruptcy trustee to oversee everything and make sure that every bankruptcy case is administered fairly.

Many bankruptcies are completed in as little as four to six months, meaning that folks are completely out of debt in about half a year, while a lot of other bankruptcies can take up to five years to complete. In either case, the total amount paid to get out debt is usually less than what's owed, and in many instances the total amount paid is far less than what's owed since Chapter 7 bankruptcy doesn't involve a repayment plan.

As soon as you file bankruptcy the automatic stay goes into place and creditors must stop contacting you and must stop all collection efforts. Creditors can't refuse to allow their debts to be part of your bankruptcy unless they can prove some type of fraud on your part. Additionally, there are no tax consequences for any of the debt that's eliminated in bankruptcy.

The entire point of bankruptcy is to give you a fresh start. We often tell folks that bankruptcy isn't about your past, it's about your future. Many folks start feeling relief as soon as we start working on their case, and by the time we file their case and we get to their 341 meeting they're feeling like a new person.

Chapter 7 vs. Chapter 13 Bankruptcy

Chapter 7 bankruptcy is what most folks think of when they think about bankruptcy. That is, it's a process that doesn't involve a repayment plan but lead to certain property of yours being taken and sold so that the proceeds can be distributed among your creditors. This is why you'll sometimes hear Chapter 7 referred to as a liquidation bankruptcy. Chapter 7 is great for eliminating qualifying unsecured debts like medical debt, credit card debt, personal loans, signature loans, title loans, and toll bills to name a few. Despite the possibility that you can loose property in a Chapter 7, the vast majority of Chapter 7 cases that are filed are "no asset" cases. A "no asset" case is a case where all of the debtor's property can be protected with bankruptcy exemptions, leaving nothing for the trustee to take and sell. Chapter 7 is typically a quick process, with most cases resolving in about four to six months. In order to file a Chapter 7 you must qualify based on your income or passing the means test.

Chapter 13 bankruptcy, on the other hand, is a great option for folks who don't qualify for Chapter 7 or folks who are behind on payments for secured debt. Chapter 13 can also be a good idea for folks who have tax debt that they need to pay off (this is because the prioritization for how debts are paid can lead to tax debts being full paid off, other unsecured debts eliminated, and all of that with affordable monthly payments). It involves an affordable repayment plan that's determined by how much disposable income you have left over each month after you pay for your necessary expenses. Over the course of your three to five year repayment plan, you'll repay a percentage of your unsecured debt and the remaining unpaid balance will get discharged at the end of your plan. Chapter 13 can also help eliminate negative equity in vehicles if you purchased the vehicle more than 910 days before filing bankruptcy.

Bankruptcy law is the culmination of the bankruptcy code, federal rules of bankruptcy procedure, federal law, and state law. It can be complex and the summaries provided above are short and sweet. You should reach out to us and talk to our Austin bankruptcy lawyer to see how we can discuss your financial situation and explain how bankruptcy can help.

How Bankruptcy Affects Your Financial Future

Everyone wants to talk about how bankruptcy will ruin your future and make things harder. But here's the thing, debt is actually what ruins your credit and makes it difficult to get approved by lenders. Bankruptcy is an effect of debt. Yes, it leaves a negative mark that will be on your credit report for seven to ten years, but it comes with a trade off because it gets you out of debt and allows you to begin building good credit.

If you're in debt and you do nothing, your credit will continue to suffer. If you're in debt and you file bankruptcy, depending on your credit score you may see an immediate dip or bump in your credit score, but through time your score will inevitably begin increasing. In fact, you can qualify for a VA of FHA mortgage two years after your debt is discharged, you can qualify for a USDA mortgage three years after your discharge, and you can qualify for a conventional mortgage four years after your bankruptcy discharge.

Schedule a Consultation with an Austin Bankruptcy Lawyer

Notepad saying "if the plan doesn't work, change the plan"

If you're wondering "should I do debt settlement or bankruptcy," you should approach debt settlement cautiously and make sure you fully understand the risks. Debt settlement can lead to you getting sued, it can lead to significantly increased balances owed when creditors refuse to settle, and it can lead to you owing taxes to the IRS because any debt that's forgiven is considered taxable income. The CFPB says that it's risky and warns that it can leave you deeper in debt than when you started.

We know that bankruptcy has a bad reputation, but we know that much of the negative attention on bankruptcy is inaccurate, misleading, or mistaken. Bankruptcy is one of the fastest and cheapest ways to get out of debt, and once you're out of debt you can begin taking steps to rebuild your credit. This means that many folks who file bankruptcy are debt free and have several years of good credit, post-bankruptcy, by the time they would be wrapping up a debt settlement program if they chose that instead.

Getting out of debt is possible. All you have to do is take the first step. Reach out to us today to schedule your free consultation with out Austin bankruptcy lawyer. During the consultation, we'll review your specific financial situation and provide legal advice that's tailored to you to help you get out of debt. Our Austin bankruptcy lawyer will help you understand the pros and cons of the bankruptcy process, and if you want to discuss other debt relief options he can help you understand the benefits and drawbacks of them as well.

Working with our Austin bankruptcy attorney ensures that you have a knowledgeable professional on your side who can help protect your rights and navigate the complex patchwork of law and federal court procedures. You can call us or click here to book your free consultation.

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