Credit Counseling vs. Debt Settlement vs. Bankruptcy

If you have more debt than you can afford, you might be considering credit counseling, debt settlement (also called debt relief), or even bankruptcy. This article covers all three solutions, including:

• How credit counseling works

• How debt settlement works

• How bankruptcy works

• Pros and cons of debt solutions

You will learn how to choose between credit counseling, debt settlement, and bankruptcy and come up with the best solution for your debt problem.

Credit Counseling vs Debt Settlement

Comparing credit counseling vs. debt settlement is easy because they are very different. Credit counseling commonly includes customer education and debt management plans. Credit counselors may negotiate lower interest rates with your creditors, get them to waive penalties and fees, or convince them to reduce your monthly payment. Counselors can even get creditors to bring past-due accounts current in some cases.

How does credit counseling work?

The debt management plan, or DMP, is an essential part of credit counseling services. You enroll your unsecured debts like credit cards, personal loans, and payday loans. You will probably be required to close most or all of your credit cards. Your counselor communicates with your creditors and creates a plan with a single monthly payment. You pay into the program, and the counselor distributes your payment among your creditors.

The National Foundation for Credit Counseling governs nonprofit credit counseling services and can help you find a reputable counselor.

How does credit counseling affect your credit?

No one reports to credit bureaus if you’re going through credit counseling. But how does a debt management plan affect your credit score?

Enrolling in a DMP can temporarily lower your credit score. That’s because you’ll be closing credit cards and other lines of credit. If you’re already maxed out, there won’t be much effect. But if you have available credit and close your account, your credit utilization ratio will increase. 

If, for instance, you have $10,000 in credit and your total balance is $5,000, your utilization is 50%. But if you close your credit lines, your utilization becomes 100%. And because utilization makes up 30% of your credit score, you will see some damage. 

On the other hand, if your counselor gets creditors to re-age your past-due accounts and report them current, your scores would improve. And in the long run, if you pay off your balances and don’t run up additional debt, your finances and credit rating will become much healthier. 

Credit counseling success rate

According to the Federal Trade Commission (FTC), only 21% of consumers successfully complete their debt management plans. This is because a slight interest rate reduction plus waiving over-limit fees and late charges won’t help if the debt is overwhelming. 

The FTC states, “…it appears that only consumers with considerable disposable income left over each month are able to get out of debt through a DMP.” The report further states that if consumers are not able to significantly lower the amount that they owe, “they’re more likely to fail in completing a three to five-year DMP.” 

Pros and cons of credit counseling

Credit counseling and debt management plans have their place. If you can establish a plan that will clear your debts in three to five years, and you can afford the monthly payment, it’s a good solution. Here are the pros:

• Non-profit credit counselors are regulated, and their fees are restricted. 

• Credit counseling teaches you how to manage your debts and budget effectively.

• Credit counseling does little harm to your credit score in the short term and can increase it in the long run.

• Consolidating debt into a DMP simplifies your payments.

• Reducing your interest rate can help you pay your debts off faster.

And here are the cons:

• Credit counseling and DMPs have a relatively low completion rate.

• Credit counseling does not reduce the amount you owe.

• Debt management plans don’t work if the payment is unaffordable.

Debt management plans and credit counseling are good solutions for people who are not in serious debt trouble. 

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Debt Settlement 

Debt settlement is a more drastic solution for bigger problems. Debt settlement means negotiating with your unsecured creditors and convincing them to accept less than you owe as payment in full. You can attempt debt settlement yourself or work with a debt relief company.

How does debt settlement work?

Most debt settlement clients don’t have a lump sum to offer their creditors. Instead, they stop paying their unsecured debts and put that money into a debt settlement fund. Skipping payments accomplishes two things – you accumulate a lump sum to offer creditors, and unpaid creditors become more inclined to accept less than the full amount – they’d rather have partial payment than no payment. 

How does debt settlement affect your credit?

Debt settlement impacts your credit in several ways. Creditors who accept less than the full amount due usually report that fact to credit bureaus. That’s a fairly serious event. But the most harm occurs when you skip payments to your creditors. 

If you’re already months behind on your payments, you’ll not notice much of a drop. But if your credit score is good or excellent and you start missing payments, expect a savage decline in your scores. 

According to FICO, the most commonly used credit scoring model, a person with a 680 credit score would lose 45 to 65 points after debt settlement for one credit card. But a consumer with a 780 credit score would lose 140 to 160 points. 

However, average consumer credit scores tend to rise upon successful graduation from a debt relief program. The American Fair Credit Council found that debt settlement clients typically improved their credit scores by 60 points within six months after settling their last debt. And scores continued to rise. However, that’s not guaranteed – success depends on your ability to control and afford your debt in the future.

Debt settlement success rate

According to the FTC, “Completion rates range from 35% to 60%, with the average around 45% to 50%. While most companies defined a completion as having all debts settled, there were two that considered a client completed if they had settled at least 80% of the debt and one if they had settled at least 50% of the debt.”

Debt settlement enjoys a higher success rate than Chapter 13 bankruptcy or credit counseling. The FTC explains that the higher rate is likely because the consumer has more control over the process. “The consumer debtor is in the best position to determine the feasibility of and likelihood of compliance with a repayment plan. By empowering the debtor with this ability and combining that with the constant ‘hand-holding’ of the debt settlement company’s customer service representative, there is a greater likelihood of completion with a debt settlement program.”

Pros and cons of debt settlement

Debt settlement can be an effective way to get rid of debt faster and make repayment more affordable. Here are the pros of debt settlement:

• Debt settlement has a higher success rate than credit counseling.

• Debt settlement reduces what you have to pay.

• The process is private and does not involve the court system like bankruptcy.

• Debt settlement does less damage to your credit score than bankruptcy.

• According to the FTC, debt settlement is more affordable than debt management.

• Consumers have more control over the process with debt settlement because they decide if an agreement is acceptable and only pay for accepted settlements.

Of course, there are downsides to debt settlement, and some are significant.

• If you have a high credit score, debt settlement can drop it by over 100 points.

• When skipping payments, expect calls, letters, and other forms of contact from your creditors. They may even choose to sue you.

• Creditors are not obligated to participate in debt settlement, and there is no guarantee that they will. 

• Professional debt settlement costs are substantial, typically ranging from 15% to 25% of the enrolled balances.

Amounts forgiven in debt settlement are taxable unless you qualify as insolvent, meaning your debts exceed your assets (you’d file Form 982 and use the worksheet on Publication 4861). So if you’re insolvent, this is a pro. If you’re not, and your settlement is taxable, it’s a con.

Bankruptcy vs. Debt Settlement

Bankruptcy vs. debt settlement is a more complex analysis. The two common types of bankruptcy available to consumers are Chapter 7 and Chapter 13. Bankruptcy costs include filing fees, which run a few hundred dollars, and attorney fees if you have professional help. Those can run into the hundreds or thousands.

How does bankruptcy work?

People file for bankruptcy when they need protection from the collection efforts of their creditors. Chapter 7 is what most people think of when they consider bankruptcy. 

With Chapter 7, you list your assets and liabilities for the bankruptcy court. The judge determines what assets the court will take from you (some things like an inexpensive car or work tools may be exempt). And then it decides how much your creditors will get. Your unsecured loans are discharged and wiped out with a Chapter 7 discharge. Chapter 7 takes about 90 days to complete. 

However, you can only file Chapter 7 if your income is so low that you’re incapable of repaying even part of what you owe. If you fail the Chapter 7 Means Test, you can’t file. Most who fail file Chapter 13. Other people who choose Chapter 13 have assets that they don’t want to surrender. They’d rather use their income to repay some or all of what they owe. 

With Chapter 13, you provide your income and debt information to the bankruptcy court, and the judge decides how much you can afford to pay into a Chapter 13 plan and how long you must pay it (generally three to five years). You submit your tax returns every year, and the court may adjust your payment. Payments can be high, and you have no say over the amount.

Chapter 7 vs. debt settlement

Chapter 7 bankruptcy is like debt settlement in that you lose some assets and discharge debt for less than you owe. With Chapter 7, the court takes what you have, gives it to your creditors, and wipes out your debts. Neither you nor your creditors have any say in the decision. With debt settlement, you reach an agreement with your creditors and part with a lump sum of money to zero your accounts. 

The differences between Chapter 7 and debt settlement include:

• Chapter 7 bankruptcy takes about 90 days, while debt settlement takes two to four years.

• Amounts discharged in Chapter 7 are non-taxable. They are taxable with debt settlement unless you’re insolvent. Complete the worksheet on Publication 4861 before deciding between bankruptcy and debt settlement. 

• Bankruptcy creates a public record, and a Chapter 7 bankruptcy can remain on your credit report for up to ten years. Debt settlement is private and goes off your credit history after seven years. 

Chapter 13 vs. debt settlement

A Chapter 13 bankruptcy is similar to debt settlement in that you make monthly payments into a plan for several years before you discharge your unsecured debts. The bankruptcy trustee collects your payment and distributes it among your creditors. As with debt settlement, you can discharge your balances for less than the full amount owed. Like debt settlement, Chapter 13 bankruptcy takes several years to complete. And like debt settlement, Chapter 13 stays on your credit report for up to seven years after filing.

Here are some differences between debt settlement and Chapter 13 bankruptcy:

• Creditors are required to participate in Chapter 13. They can’t opt out and choose to sue you.

• Unlike debt settlement, you have no choice in the amount you pay to discharge your debts through bankruptcy. The judge decides, and it’s not negotiable.

• Chapter 13 creates a public record, while debt settlement is private. 

• Amounts discharged in Chapter 13 are non-taxable. Debt forgiven in a settlement is taxable unless you are insolvent.

Bankruptcy success rate

Chapter 7 and Chapter 13 have very different success rates. Chapter 7 discharges take about 90 days and require nothing from the filer except paperwork and turning over non-exempt assets. The filer gets a clean slate in just a few months, so it makes sense that the success rate for Chapter 7 is about 96%.

Chapter 13 filers must pay most or even all of their disposable income into a plan for years. If the filer fails to make the mandatory payments, the bankruptcy judge will likely dismiss the filing and end protection from creditors. The judge may convert this filing to a Chapter 7 if the consumer is eligible. According to the FTC, the Chapter 13 bankruptcy success rate is just 33%.

How does bankruptcy affect your credit?

Chapter 7 bankruptcy remains on your credit reports for ten years from the filing date; a Chapter 13 bankruptcy will affect your credit reports and scores for seven years. However, over time, the impact on your score will fade. 

According to FICO, the higher your starting score, the more points you’ll lose by filing  bankruptcy. If your score is 680, expect to lose 130-150 points. And if you’re starting at 780, a bankruptcy filing will cost you 220-240 points.

Pros and cons of bankruptcy

Bankruptcy is a drastic solution for serious problems. And it may be the right solution for you. Here are bankruptcy pros:

• Your creditors must participate in your bankruptcy and accept what the judge tells them.

• Amounts discharged in bankruptcy are non-taxable.

• Chapter 7 bankruptcies take just a few months.

• Bankruptcy can be less costly than debt settlement for higher debt balances.

• Creditors must stop collection efforts once you file.

Bankruptcy can get you out from under extreme debt loads and help you start over. But it comes at a cost. Here are the cons of bankruptcy.

• You don’t control the process – the judge decides how much you pay each month or what assets you must surrender. It’s not negotiable.

• Bankruptcy is public. And a filing can make you ineligible for work in certain industries.

• You may pay more in a Chapter 13 plan or Chapter 7 discharge than you would with debt settlement because you don’t get to negotiate.

• Professional bankruptcy help from an attorney can be expensive, and you must pay much or all of it upfront. In addition, you can’t put bankruptcy fees on a credit card. Expect to pay $1,500 to $3,000 for an attorney-assisted Chapter 7 and $3,000 to $4,000 for a Chapter 13.

Credit Counseling, Debt Settlement or Bankruptcy: How to Choose

So, how do you choose among these solutions? Ask yourself these questions:

• Do I qualify as insolvent? Insolvency makes debt settlement more attractive.

• What’s my credit score now? People with high scores have more to lose by filing bankruptcy or settling debt.

• How much can I afford to pay into a plan? Avoid debt management plans if you can’t afford the payments. 

• How long would it take to get rid of debt? The longer a plan takes, the lower the odds of successful completion.

• Will a public record embarrass me horribly or harm my employment? Bankruptcy may be off the table in that case.

There are many solutions for those trying to deal with unaffordable debt. The important thing is to start problem-solving as soon as possible and stop ignoring your debt problems.

Jane's journey to financial stability

Meet Jane, a dedicated and hardworking nurse and single mother of two. She has $20,000 in credit card debt. It's due to unexpected medical bills and home repairs. She is exploring her options to secure a better financial future for her family.

Jane compares three debt relief options.

Here’s a breakdown of the three debt relief options she’s considering:

How it works

• Credit Counseling: Jane works with a counselor to create a debt management plan.

• Debt Settlement: Jane or a professional debt settlement firm negotiates with creditors to pay a lump sum that is less than she owes.

• Bankruptcy: Jane files for Chapter 7 or Chapter 13 bankruptcy.

Monthly payment

• Credit Counseling: $300 if she can secure lower interest rates.

• Debt Settlement: $200 towards a settlement fund.

• Bankruptcy: varies based on disposable income.

Duration

• Credit Counseling: 3-5 years.

• Debt Settlement: 2-4 years.

• Bankruptcy: 3-6 months (Chapter 7), 3-5 years (Chapter 13).

Impact on credit

• Credit Counseling: Moderate, improves over time.

• Debt Settlement: Depends on how bad credit is to start with. May initially lower credit score. Clearing debts could help her manage her finances and build strong credit going forward. 

• Bankruptcy: Negative impact FOR 7-10 years. Clearing debts could help her manage her finances and build strong credit going forward. 

Costs

• Credit Counseling: Monthly fee of $25 or more.

• Debt Settlement: Settlement fees (15%-25% of settled debt unless Jane handles negotiations herself).

• Bankruptcy: Court and attorney fees ($1,500-$3,000).

Pros

• Credit Counseling: Possibly lower interest rates, consolidated payments, less credit impact. 

• Debt Settlement: Reduces total debt, consolidated payments, quicker relief. 

• Bankruptcy: Legal protection from creditors, potential to walk away from debts.

Cons

• Credit Counseling: Must close all credit accounts, ongoing monthly fee.

• Debt Settlement: possible credit score damage, potential tax on forgiven debt, fees would eat into any debt reduction unless Jane negotiates for herself.

• Bankruptcy: Long-lasting credit impact, public record, costs.

Jane needs to make a decision - top considerations

Recommendations for Jane

Based on Jane’s situation:

• If she can manage $300 monthly, credit counseling is advisable for less impact on her credit score.

• If she can afford some monthly payments but not $300, debt settlement may be more manageable. And she may end up getting partial debt forgiveness.

• If she can't can’t afford to pay much toward her debts, bankruptcy could help the most. Depending on her income level, she might have to give up some of the things she owns.

Jane wants to make the best decision for her family's future. Her goal is to find the best debt relief option. Each option has unique benefits and challenges. Jane's choice will depend on her needs and finances.