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. But what is the difference between them and how can you decide which is right for you? 

Let’s explore all three possible debt relief options and go over:

• How credit counseling works

• How debt settlement works

• How bankruptcy works

• Pros and cons of each of the different debt solutions

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

Credit Counseling vs. Debt Settlement

Credit counseling is purely educational. An accredited credit counselor will help you learn how to manage your money and debt. If you need credit card debt relief, the credit counselor may recommend a debt management plan (DMP), and that’s what we’ll compare to debt settlement. 

In a DMP, credit counselors may negotiate lower interest rates with your creditors, get creditors to waive penalties and fees, or convince creditors to adjust your monthly payment. Counselors might even get creditors to bring past-due accounts current. A DMP might be a good choice if you can afford to pay off all of your debts in three to five years and you want professional help managing your money.

Debt settlement works differently. It involves negotiating with creditors to let you close out the debt for less than the full amount you owe. Debt settlement can be a solution if you have a substantial amount of debt that you intended to repay, but now you can’t. 

Let's take a closer look at both of these options. 

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How does credit counseling work?

Nonprofit credit counseling agencies are typically funded by credit card issuers. That’s why the cost to you is very low (typically $25 to $40 per month) and the credit card companies are sometimes willing to be flexible on the interest rate. Their goal is to make it easier for you to fully repay your debts.

You'll enroll your unsecured debts (such as credit cards, personal loans, and payday loans). You’ll probably be required to close most or all of your credit cards. Your creditors or the counseling agency might periodically check your credit report to make sure you’re sticking with this part of the agreement. If you break any part of the agreement, your creditors could back out of your plan.

Your counselor will create a plan with a single monthly payment. You pay into the program, and the counselor distributes the money to your creditors. This simplifies your payoff process since you'll only have one payment. 

You can find an accredited credit counseling agency through the National Foundation for Credit Counseling (NFCC) or the Financial Counseling Association of America (FCAA).  

How does credit counseling affect your credit?

If your creditors agree to re-age your past-due accounts, your credit standing could improve. Re-aging means accounts are reported as on-time, and you get another chance to avoid paying late. 

That said, you could see a lower score overall when you enroll in a DMP. That's because you’ll be closing credit cards and other lines of credit before they’re paid off. A big part of your credit score is based on how much you owe compared to how much available credit you have. Once you close a credit card, the available credit drops to zero.

Your score could improve over time as you pay down those closed accounts.  

Say, for example, you have a $5,000 balance on a credit card with a $10,000 limit. Your utilization is 50% in this case. But if you close this account and drop to $0 in available credit, your utilization becomes 100%. Credit utilization is a significant factor affecting your credit scores.  

In the long run, if you pay off your balances and don’t run up additional debt, you’ll be on better financial footing. That puts you in the best position to build and maintain a healthy credit standing.  

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 and a waiver of over-limit fees and late charges can’t entirely compensate for the very high required monthly payment. 

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 can’t 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 payments, it’s a good solution to consider.

Here are the pros of this approach:

• Nonprofit credit counselors are regulated and their fees are restricted. 

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

• Credit counseling could help you build a stronger credit profile in the long run.

• A DMP could simplify your payments.

• Reducing your interest rate could help you afford your payments.

And here are the cons:

• DMPs have a relatively low completion rate.

• Credit counseling doesn't reduce the amount you owe.

• You could temporarily lose access to credit.

• You could pay a monthly fee to the credit counseling agency.

Debt management plans and credit counseling are good options for people who have enough disposable income to stick with the debt payments over several years.

Debt Settlement 

Debt settlement is for people with overwhelming debt problems. Debt settlement involves negotiating with your unsecured creditors and convincing them to accept less than you owe as payment in full. The rest is forgiven. 

Anyone can negotiate with their own creditors. If you don’t want to, you can work with a debt relief company who can negotiate with your creditors on your behalf.

Debt settlement means you don't pay back the full amount you owe. This benefits you since you spend less money to clear your debts. Settling could help you get rid of your debt faster than by making minimum payments.  

How does debt settlement work?

Debt settlement involves convincing a lender to accept a reduced amount. Lenders may agree if they think you'll be unable to pay the full amount due. From their perspective, it’s better to get something than nothing. Taking you to court for a debt is expensive and has no guarantees.  

When you settle debt, you might agree to pay the reduced amount in one lump sum. However, if you’re struggling with debt, you might not have money in the bank to offer their creditors. You’d have to save it up.

Most people choose to stop paying their unsecured debts so they can afford to put that money into a debt settlement fund instead. Skipping payments accomplishes two goals. One, you accumulate money to offer creditors. Two, it signals that you're struggling financially. Creditors may be less willing to negotiate if you’re caught up on all your bills. 

You could face collections efforts from your creditors and even a debt lawsuit if you’re not making your payments. 

At Freedom Debt Relief, if a creditor takes legal action against you for an enrolled debt, we may engage a Legal Partner Network attorney. This attorney will attempt to negotiate a settlement with the creditor and keep the case out of court. This service is free for qualifying clients who have made their monthly deposits on time. The offer doesn't apply to legal action taken before you enrolled, or to legal action taken on debts that aren't enrolled.

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 and this shows up on your credit record. That’s better than a collection account but less favorable than “paid as agreed.”

The most harm to your credit score occurs if you skip payments to your creditors. 

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

According to FICO, the credit score company, a person with a 680 credit score could lose 45 to 65 points after settling one credit card account. A consumer with a 780 credit score would lose 140 to 160 points. 

As you settle your debts and become more financially stable, your credit score could improve. When you finally take control over your finances, you’re in a better position to stop missing payments and maxing out your cards. 

Debt settlement success rate

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. 

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 could reduce the total amount you have to pay.

• The process of debt settlement is private and doesn't involve the court system.

• Debt settlement may be more affordable than debt management plans.

• You have more control over the process. You decide if an agreement is acceptable and only pay for accepted settlements.

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

• Your credit score could suffer.

• If you stop paying your bills, expect calls, letters, and other forms of contact from your creditors. They may even choose to sue you to try to collect your unmade payments and unpaid debt.

• Creditors aren't obligated to participate in debt settlement, and there's no guarantee that they will. 

• Professional debt settlement companies charge a fee for settling your debts. Fees typically range from 15% to 25% of the enrolled balances.

Amounts forgiven in debt settlement may be taxable. If you’re insolvent, meaning your debts are bigger than your assets, you won’t be subject to federal income tax on the forgiven amounts. (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.

Debt Settlement vs. Bankruptcy

Bankruptcy is a more formal legal process, and the specifics of how it unfolds will depend on what kind of bankruptcy you file. 

The two common types of bankruptcy available to consumers are Chapter 7 and Chapter 13. Chapter 7 has more limited availability, while Chapter 13 can take longer to complete. Both Chapter 7 and Chapter 13 require you to pay filing fees, which run a few hundred dollars, and attorney fees if you have professional help. Attorney fees 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. It's a formal legal process for discharging or eliminating debt.  

Chapter 7 bankruptcy 

Chapter 7 is what most people think of when they consider bankruptcy. 

When you file for Chapter 7 bankruptcy, you list your assets (things you own) and liabilities (debts) for the bankruptcy court. The judge decides whether you have to give up any assets. You’re allowed to keep some assets, such as household goods and tools for your job. The assets you lose are sold at an asset sale. The court then distributes this money among your unsecured creditors.

If you qualify, a Chapter 7 discharge wipes out your unsecured loans. This can include loans like payday loans, personal loans, medical debt, and credit card debt. 

You can’t eliminate secured debt, such as a home mortgage or car loan, as part of Chapter 7. If you can’t repay those debts, the creditor can foreclose on the home or repossess the car.  

Chapter 7 takes a few months to complete, so you can be free of your unsecured debt quickly if you qualify for this type of bankruptcy. 

You can only file Chapter 7 if your income is so low that you’re incapable of repaying even part of what you owe. You'll need to complete a Chapter 7 means test, which measures whether you have the means to repay all or part of your debt.  

If you fail the Chapter 7 means test, you aren't able to file for this type of bankruptcy. 

Most people who fail the means test file for Chapter 13 bankruptcy. Some people also choose Chapter 13 instead of Chapter 7, even if they could qualify for Chapter 7 bankruptcy, because they have assets that they don’t want the court to sell.  

Chapter 13 bankruptcy

In Chapter 13 bankruptcy, you don’t have to pass a means test, and the court won’t sell your assets. But it takes much longer for any debt to be discharged.

With Chapter 13, you enter into a repayment plan that lasts for five years. If your income is low, your plan may only last for three years. The court will periodically reverify your income, and adjust your payment amount if necessary. The bankruptcy judge will take your income and debts into account to decide on the amount of your monthly payment. A bankruptcy trustee distributes the money among your creditors.

Chapter 7 bankruptcy vs. debt settlement

When you compare debt settlement vs. bankruptcy, the type of bankruptcy matters. 

Chapter 7 bankruptcy is similar to debt settlement in that you can get rid of debt for less than the full amount you owe. However, there are important differences. 

With Chapter 7, the court could take some of the things you own and sell them to repay your creditors. For example, if you have more than one car, you probably won’t be able to keep them both. 

With debt settlement, you reach an agreement with your creditors.  You also don't have any obligation to sell the things you own and give the money to your creditors.  

The differences between Chapter 7 and debt settlement include:

• Timing: Chapter 7 bankruptcy takes a few months. The timing for debt settlement can vary depending on how quickly you negotiate an agreement with your creditors, and how quickly you save enough money to make an offer they’ll accept. 

• Collections: Chapter 7 forces your creditors to stop collection efforts. A debt settlement program can’t stop collections. Many creditors voluntarily stop collections once they know you’re working on a debt settlement offer.

• Tax consequences: Debt discharged (forgiven) in Chapter 7 bankruptcy isn't taxed. Debt forgiven through debt settlement could be taxed, unless you’re insolvent.  

• Privacy: Bankruptcy creates a public record, and a Chapter 7 bankruptcy can remain on your credit report for up to 10 years. Debt settlement is private and goes off your credit history after seven years. 

Chapter 13 bankruptcy vs. debt settlement

A Chapter 13 bankruptcy is similar to debt settlement in that you’ll typically make monthly payments into a plan for several years before you get rid of your unsecured debts. 

If you file for Chapter 13 bankruptcy, the bankruptcy trustee collects your payment and distributes it among your creditors. If you pursue debt settlement, you'll usually deposit a set amount into a dedicated account until you have saved up enough money to make a reasonable offer to a creditor. 

With both Chapter 13 bankruptcy and debt settlement, you could end up getting rid of your debt for less than the full amount owed. Both strategies typically take several years to complete. Both can stay on your credit report for seven years. 

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

• Control: In debt settlement, you can directly negotiate with your creditors. The court decides on your payment amount for Chapter 13.

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

• Tax consequences: Amounts discharged in Chapter 13 are non-taxable. Debt forgiven in a debt settlement could be taxable unless you're insolvent.

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

Bankruptcy success rate

Chapter 7 and Chapter 13 have very different success rates. 

Chapter 7 discharges take a few months and require nothing from you except paperwork and turning over any assets that the court says you’re not allowed to keep. You get a financial reset in just a few months. The success rate for Chapter 7 is about 96%.

In a Chapter 13, you must pay most or all of your disposable income into your plan for years. If you fail to make the mandatory payments, the bankruptcy judge will likely dismiss the filing. That means your bankruptcy case ends without any debt forgiveness, and you no longer get any protection from creditors. About half of Chapter 13 cases fail.

How does bankruptcy affect your credit?

Chapter 7 bankruptcy remains on your credit reports for 10 years from the filing date. A Chapter 13 bankruptcy will affect your credit reports and scores for seven years.

The impact of bankruptcy on your credit can be substantial, depending on your situation. The higher your starting score, the more points you’ll lose by filing bankruptcy. If your score is 680, you could lose 130-150 points. And if you’re starting at 780, a bankruptcy filing will cost you 220-240 points. 

Over time, the impact on your score will fade. It’s possible to begin rebuilding your credit almost immediately after bankruptcy. Over time, if you pay your bills on time, keep debt low, and avoid applying for credit accounts often, the bankruptcy will impact your credit less and less. 

Pros and cons of bankruptcy

Bankruptcy is a legal process for dealing with debt. It can be a lifeline for those who need it. Here are the advantages of bankruptcy: 

• 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.

• Creditors must stop collection efforts, including mortgage foreclosure, once you file for bankruptcy.

Bankruptcy could 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. Laws determine who's eligible to file and which creditors get paid. 

• Bankruptcy is public, and filing for bankruptcy can make you ineligible for work in certain jobs.

• You might pay more in a Chapter 13 plan than you would with debt settlement. Besides making payments toward the debts, you’ll also pay court fees and probably attorney fees. And you don’t get to negotiate.

Credit Counseling vs. Debt Settlement vs. Bankruptcy: How to Choose

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

• Am I insolvent? Explore debt settlement and Chapter 7 bankruptcy.

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

• How much can I afford to pay into a plan? Research a debt management plan if you can afford to fully repay your debt within about five years.

• How long would it take to get rid of my debt? The longer a plan takes, the harder it might be to successfully complete it.

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

• What’s my financial outlook? Debt settlement is for someone experiencing financial hardship and who genuinely can’t afford to fully repay their debts. Chapter 13, on the other hand, is for someone who expects to have an income but needs protection from creditors.

There are many solutions for those trying to deal with unaffordable debt. The important thing is to take action as soon as possible to solve your debt problems.

Jane's journey to financial stability

To better understand how these debt relief options could work in real life, let's take a look at an example. 

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's 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:

• 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.

Here's how much Jane's monthly payments might be under each plan: 

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

• Debt Settlement: $200 toward a settlement fund.

• Bankruptcy: varies based on disposable income.

Here's how long Jane would be working to resolve her debt:

• Credit Counseling: 3-5 years

• Debt Settlement: 2-4 years

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

Here's how each option would affect her credit:

• Credit Counseling: Moderate impact that improves over time.

• Debt Settlement: Depends on her starting credit score. May initially lower credit score but 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. 

Here's how much her costs would be with each approach: 

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

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

• Bankruptcy: Court and attorney fees typically totaling $1,500 to $3,000.

Here are the biggest advantages of each option: 

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

• Debt Settlement: Reduces total debt, consolidates payments, and could bring quickest relief. 

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

Here are the biggest disadvantages of each:

• Credit Counseling: Initial credit score damage, must close credit accounts, ongoing monthly fee, and a big monthly payment.

• Debt Settlement: Credit score damage, potential tax on forgiven debt, potential fees  unless Jane negotiates for herself.

• Bankruptcy: Credit score damage, public record, might have to give up some belongings, potentially high monthly payment, court and attorney fees.

Jane’s decision: Top considerations

Recommendations for Jane

Based on Jane’s situation:

• If she can manage $300 monthly, credit counseling is advisable. There will be an impact on her credit score, but she avoids having collections or bankruptcy on her credit report.

• 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 or anything toward her debts, Chapter 7 bankruptcy could help. If she doesn’t qualify for Chapter 7 but she wants collection efforts to stop, Chapter 13 could help.

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.