Debt Settlement vs Bankruptcy

Most people who have thought about filing for bankruptcy have also considered whether they should instead do a debt settlement program. Debt settlement and bankruptcy have both their benefits and drawbacks and its important that you understand each so that you can decide whether debt settlement or bankruptcy will benefit you the most. This is a two part article in which I will first discuss debt settlement. In the second part I will explain how bankruptcy is different.

What is Debt Settlement?

Debt settlement involves negotiating with the creditor to reduce what is owed on the debt, in exchange for a lump sum payment to the creditor (debt collection company). For example, if you owe $10,000 on a credit card, a debt settlement company or attorney will try to negotiate your debt with the debt collection company for a percentage of what you owe. Generally this can range on average from 25% to 75% of what you owe on the debt. This of course can help reduce substantially what you owe. Lets assume that the debt settlement company was able to negotiate your $10,000 to 25% of what you owe. In this case you would pay $2500 to settle the debt. If the collection agency or creditor agrees to a settlement you will have to pay the amount within a few months or as a lump sum payment. Keep in mind that debt settlement only works for unsecured debt like credit cards, medical bills, and personal loans and not on secured debt.

Advantages to Debt Settlement

If you have access to funds either of your own or through friends or relatives then you may be able to save a large amount of money when settling your debt. This is especially the case when your debt has been sold off to debt collection companies. These companies usually pay pennies on the dollar to have the right to collect on your debt. Most collection companies are willing to negotiate for a lump sump payment that is substantially less then what is owed on the debt.

Disadvantages to Debt Settlement

Unfortunately debt settlement carries with it many disadvantages that can outweigh the benefits of reducing your debt. It is important that you are aware of these issues so that you don't end up in a worst position then you were before hiring a debt settlement company.

1) Heavily unregulated industry - Due to a lack of regulation in the industry the industry is filled with companies that take advantage of consumers already in dire need. These companies may charge ridiculous up front fees for settling your debt, collect money without really doing the work or delay the settling of your debt to collect more fees from you. If you decide to hire a debt settlement company to settle your debt then it is important that you

Avoid Companies Who:

• Charge Large Up Front Fees - If you have already paid them then what is the incentive for them to work hard to settle your debt and get you debt free.
• Charge On-going Monthly Fees- If they continue to collect monthly fees until all of your debt is settled then they have an incentive to not settle your debt. The longer you are in the program the more money they make from you.

Look for Companies Who:

• Charge Only Once Your Debt is Settled - A company who is willing to be paid only after they have settled the debt is more likely to work hard for you then a company who has already been paid or who you are making monthly payments to.
• Are Part of a Debt Settlement Trade Association- Although for the most part the industry is unregulated there are two well known trade associations who provide a list of member companies. The two major debt settlement trade associations are the United States Organization for Bankruptcy Alternatives and the Association of Settlement Companies. Trade associations members generally must meet specific standards that are outlined by the organization.
  

2) Requires Lump Sum Payments to Creditors - If you are having trouble paying your monthly credit card bill, you probably don't have large sums of money sitting in bank accounts or friends who can lend you large sums of money. Debt settlement requires that you have access to quite a bit of money that you can you use to pay off the settled amount. Debt collectors are not going to take installments over a large period of time for a settled debt.Of course debt settlement companies generally will have you pay a monthly amount and will accumulate these amounts in an account so that they have access to a lump sum amount to negotiate with. The problem with this is the issue below:

3) Potential for Lawsuits - During the time that a debt settlement company is negotiating your debt you are generally not paying your monthly payments to the creditor. Your monthly payments will be going to the debt settlement company. During this time a creditor can file a lawsuit against you and obtain a judgment against you. Some companies will not agree to a debt settlement and will file a lawsuit against you. If they obtain a judgment against you then you are a sitting duck for wage garnishment, levying on a bank account or placing a lien on your property.

4) Effect on Credit Report - During the time that the debt settlement company is negotiating with creditors, you are not making payments to your creditors. The creditors will be reporting late payments and any charge offs from the sale of the debt to a collection agency. Once your debt is settled you will usually have a note on your credit report that states "Paid-Settled". All of these notations and late payments will adversely affect your credit.

5) Tax Consequences - If the creditor or the debt collector cancels some of your debt as part of the debt settlement then you could potentially be liable for taxes on the canceled debt. Canceled debt is treated as income. If you owed a creditor $5,000 and you settled the debt for $2,000, then $3,000 would be considered income to you. The canceled debt is treated as if the debt settlement company had given you $3,000. You may not need to pay the taxes on this canceled debt if you are considered insolvent at the time that the debt was canceled.

6) High Failure Rate- The majority of people who are in a debt settlement program will never complete it. There is a high drop out rate in debt settlement programs. This is generally because debt settlement is rarely a quick process it can take years to complete the whole process.

Debt settlement can help some people eliminate their debt, but you should evaluate your options before deciding to hire a debt settlement company. The second part of this article will look at bankruptcy: Part 2: Bankruptcy

From Southern California Law Advocates: Riverside Bankruptcy Attorney