Debt Relief vs. Bankruptcy: What’s Right for You?

If your money problems are severe and you can’t afford your debt payments, you’re probably considering debt relief or bankruptcy. Debt settlement and bankruptcy are both drastic solutions for big money problems, and they can both reduce debt balances. When weighing debt relief vs. bankruptcy, you’ll look at four factors: privacy, control, tax consequences, and cost. 

Debt relief vs. bankruptcy definitions

What is debt relief? What is bankruptcy? They can accomplish the same thing, but they work very differently. Understanding the differences will help you decide which is better.

A bankruptcy filing is a formal request to a bankruptcy judge for protection from creditors. In this request, you indicate why you can't repay your accounts and provide a list of creditors. You also supply proof of income and a list of assets. Be truthful and thorough. 

You have to pay bankruptcy filing fees, which are between $313 and $338. You’ll also have to complete pre-bankruptcy credit counseling and a debtor education course. Total fees for those are about $100. If you hire an attorney, you’ll need to factor in that cost as well. Attorneys who specialize in bankruptcy often charge a flat fee, typically between $1,500 and $3,500.

Your county clerk’s office will record your bankruptcy filing, and anyone can view this record. Once you file, your creditors have to suspend collection attempts.

What is Chapter 7 bankruptcy?

Chapter 7 is called liquidation bankruptcy because the court takes your assets, sells them, and distributes the money to your unsecured creditors. Your creditors have to accept whatever the court offers them as payment in full. In Chapter 7 bankruptcy, it usually takes about four months from start to finish, so if a judge grants your petition, you can have your unsecured debts quickly wiped out.

Chapter 7 is only available to you if you pass a means test. You pass a means test if your disposable income is too low to pay anything to your creditors. Disposable income is money left over after you pay necessary expenses like housing and transportation and health insurance. If you fail the means test, you may not file Chapter 7. 

Chapter 7 bankruptcy remains on your credit report for up to 10 years from the filing date. Filing has a dramatic, harmful, impact on your credit score. Over time, the effect on your credit score lessens. 

What is Chapter 13 bankruptcy?

Chapter 13 is the reorganization bankruptcy. If the court decides that you can afford a payment you’ll be enrolled in Chapter 13. The bankruptcy judge or trustee examines your income and debts and determines an amount you can afford to pay each month for three to five years. This amount may take all of your discretionary income—Chapter 13 isn't meant to be easy. 

If your monthly income is less than the state median income for your household size, you pay for three years. Otherwise, it’s five years. Every year, you’ll submit tax returns. The trustee may adjust your payment if your income changes.

At the end of your term, if you’ve made your payments on time and in full, the trustee discharges the remaining balances on your accounts. 

Debt discharged in bankruptcy is usually not taxable income.

How does debt relief work?

Debt relief (AKA debt settlement) is similar to bankruptcy in that it can allow you to zero out unsecured debt for less than the amount owed. With debt relief, you offer your creditors a lump sum that’s less than what you owe them and ask them to consider your account paid in full. Many consumers hire debt settlement companies to help them negotiate with creditors.

Usually, creditors don’t accept a settlement offer if they believe you can afford to pay the entire balance. So consumers who settle debt typically stop making payments on the accounts they hope to settle. Instead, they put those payments into a debt settlement savings account. Once you begin missing payments, your creditors will probably start contacting you about your accounts. This may get very aggressive, depending on who you owe and your state laws governing debt collection.

Most people can start the negotiation process after about four months. Over time, you or your debt relief company can negotiate and settle one by one with your unsecured creditors. You can speed up the process if you save more each month or find a way to borrow a lump sum to offer, such as by borrowing against a 401(k) account or from a family member. Debt settlement typically takes two to four years to complete. There's no public filing when you settle debt because you do it outside the court system. 

With debt relief, forgiven amounts are taxable unless you’re insolvent (when your debts are greater than your assets). Debt relief can show up on your credit report in two ways—when you miss payments to your creditors, and when they close your account and accept less than the full amount due. This can impact your credit scores for up to seven years, although the effect diminishes over time. 

Pros and cons: debt relief vs. bankruptcy

Here are the pros and cons of each bankruptcy option and a debt relief solution.

Debt relief pros and cons

Debt relief pros:

• Debt relief is private. No one ever needs to know about your debt problems.

• You remain in control. You only settle when the offer is acceptable to you.

• You protect your assets. No one can force you to surrender anything or pay more than you want into a plan. 

• Credit scores tend to recover more quickly after debt settlement than bankruptcy.

Debt relief cons:

• Creditors may contact you aggressively. Whether you can legally make them stop depends on the state where you live.

• Your creditors don't have to negotiate with you. They can even choose to sue you. 

• Forgiven amounts are taxable if you aren't insolvent. 

Bankruptcy pros and cons

Bankruptcy pros:

• If you qualify for Chapter 7, you can resolve your unsecured debts in just a few months.

• Creditors can't opt out—they must accept the court’s rulings.

• You can get out of all of your enrolled debts with a Chapter 7 bankruptcy. You might get partial debt forgiveness with Chapter 13.

• Forgiven amounts are usually not taxable.

• Creditors have to stop trying to collect on your debts after you file.

Bankruptcy cons:

• Bankruptcy is public. You can't protect your privacy when you file. 

• Filing bankruptcy gives control to a judge or trustee. This person can take your non-exempt assets (Chapter 7) or your discretionary income (Chapter 13), and it's not negotiable.

• Chapter 13 bankruptcy can take up to five years and you could end up paying everything you owe, plus bankruptcy fees.

• It may take longer for your credit score to recover from bankruptcy compared with debt settlement. 

• Bankruptcy can make you ineligible for certain types of loans and jobs for a period of time.  

Summary: debt relief vs. bankruptcy

Here’s a quick rundown of the meaningful differences between debt relief and bankruptcy:

• Privacy: Debt settlement is private. Bankruptcy creates a public record.

• Taxes: Amounts forgiven in debt settlement are taxable unless you are insolvent. Amounts discharged in bankruptcy aren't usually taxable. 

• Time: Chapter 7 bankruptcy is the fastest option. Debt relief typically ranges from 24 to 48 months. Chapter 13 filers pay for three or five years. 

• Cost: DIY debt settlement costs nothing if you do it yourself. Debt relief companies charge a percentage of your enrolled debts. DIY bankruptcy filing costs a few hundred dollars. Attorney fees can be several thousand dollars. 

• Credit score: The effect on your credit score depends on how good it is to start with. If it’s already impacted by missed payments and collection accounts, the hit may be modest no matter what solution you choose. If you have a high score, any of these options will cause severe credit score damage.  

Deciding whether to go with debt relief or bankruptcy depends on which of these factors is most important to you.

Which is better: bankruptcy or debt relief?

When considering debt relief vs. bankruptcy, ask yourself these questions:

• How much unsecured debt do I have? If you have a huge amount of debt relative to your assets, bankruptcy with a lawyer can cost less than professional debt settlement.

• Would it upset me if anyone found out that I’d filed for bankruptcy? Debt settlement is the better choice if your privacy is the top concern.

• Am I comfortable going into court and dealing with filing requirements? Bankruptcy court can be stressful, and the process is complicated. You must handle it yourself or hire an attorney.

• Would a bankruptcy disqualify me for jobs or promotions in my field? If bankruptcy cancels your career, it’s probably not an option.

• Would it bother me if my creditors called me about late payments? Debt settlement can be stressful if your state law allows creditors to contact you aggressively. 

• Do I have assets that I want to protect? Only Chapter 13 bankruptcy and debt relief allow you to keep your assets. 

• Can I pass a means test? Chapter 7 is only available if you can pass a means test. Chapter 13 bankruptcy requires you to repay some or all of your unsecured debt.

• Do I qualify as insolvent? If your liabilities exceed your assets, you won’t owe taxes on forgiven amounts. That can be a major factor when deciding on debt relief vs. bankruptcy.

• What is my tax bracket? Your tax bracket matters if you won’t be considered insolvent by the IRS because it determines how much tax you’d owe on forgiven debt. That’s important when weighing debt relief or bankruptcy. 

Once you answer those questions, the debt relief vs. bankruptcy decision becomes clear.

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Comparing the costs of debt relief vs. bankruptcy

To be able to close out your debts, whether they are wiped out or reduced, some money will come out of your pocket. 

Costs of debt relief

Debt settlement companies may not collect fees upfront. You pay the debt settlement company after each debt is settled, based on a percentage of either the total enrolled debt or the amount of debt reduced. The fee is typically 15-25% of the debt being settled.

Let’s say the company negotiates your $10,000 debt down to $5,000 and charges 22% of total enrolled debt. You’ll pay the creditor $5,000 and pay the debt settlement company $2,200.

In that scenario, you’d pay a total of $7,200 instead of the original $10,000 balance (which, with interest and fees, would probably continue to grow in the absence of any intervention). A study by the American Fair Credit Council based on 2020 data found that consumers saved an average of $2.64 for each $1 paid in fees to the debt settlement company. 

Costs of Chapter 7 bankruptcy

Filing for Chapter 7 bankruptcy costs $338, not including debt counseling fees. Filing with the help of an attorney will add another $1,500 or more.

Attorney fees vary widely depending on where you live and how complicated the case is. 

Costs of Chapter 13 bankruptcy

Filing Chapter 13 bankruptcy costs $313, not including debt counseling fees. The attorney will cost an additional $3,000 to $4,000.