The basics of debt settlement
The formula for debt settlement is simple: hire a debt settlement company, stop paying your creditors, save up funds to use for settlement, then make offers with your creditors for pennies on the dollar. It sounds like a great alternative because it keeps you out of bankruptcy, but beware of the fine print.
You can be sued in debt settlement
Debt settlement requires you to stop making your regular monthly payments to creditors. However, when you stop paying your creditors, you can be sued for the full balance of what you owe and even additional amounts for their attorney fees. If a creditor gets a judgment, the judgment is an automatic lien on any real estate you own, and they can even seize your assets to satisfy the debt. The lawsuits will only stop only after settlements are reached with your creditors, and it can take years before you’ve saved up enough to settle. Even then, your creditors are not obligated to settle with you. With bankruptcy, your creditors cannot prevent you from filing, lawsuits are stopped immediately with the automatic stay, and your creditors are required to obey the bankruptcy court order discharging your debts.
Bankruptcy is cheaper
In debt settlement, creditors settle based on a percent of what you owe. If you have a lot of debt, this can drive the cost of debt settlement to an unaffordable monthly payment. The balance of what you owe can even go up until the debt is settled. With debt settlement, you never know what the final cost will be until the last debt is settled years down the road. Chapter 7 bankruptcy will always cost less than debt settlement because there are no monthly payments at all. In a Chapter 13 bankruptcy, if your assets don’t exceed your exemptions, your monthly payment is based on what you can afford to repay. You will also know early in the process what a Chapter 13 bankruptcy will cost. Almost always, your unsecured creditors will be paid less than what they will settle for in debt settlement.
When you cancel more than $600 in a settlement, the creditor will issue you a 1099-C for the difference between the current balance and the settlement amount. This may be treated as income that will trigger a higher tax bill on your income taxes. There are some exceptions to this, so speak with a CPA to see if this will apply to you. Filing bankruptcy does not trigger any income tax for the discharged debt.
The bottom line
Almost always, the only time I advise a client that debt settlement is a better alternative to bankruptcy is when they will lose assets in a Chapter 7 bankruptcy [find out what you can keep here] and when they can’t afford the payment in a Chapter 13 bankruptcy. Before attempting debt settlement, speak with me first for an honest assessment of your situation.