Debt Relief or Bankruptcy? (The Options and the Differences)

Debt relief can be a saving grace when your monthly payments become unmanageable. And debt can spiral out of control very quickly, even in the best of times. In 2020, expensive health emergencies and rampant unemployment have only compounded the issue.

But debt relief includes a wide range of strategies. And all too often, people struggle to find the right plan or get pressured into a scam by a predatory lender. If you’re feeling overwhelmed by your debt situation and are looking for the best option, here’s everything you need to know about the different types of debt relief.

What is Debt Relief and When Should You Consider It?

Debt relief generally includes any strategy that helps people who are struggling with their debt payments to make those ends meet. Usually, that looks like one of three things:

  • Getting better repayment terms (like a lower interest rate)
  • Reducing the total amount to be repaid
  • Eliminating debt accounts entirely

Debt relief sounds like all upside at first glance, but it always comes with a price (usually a negative impact on your credit score). So make sure that you’ve attempted to reduce your spending and increase your income before you consider it.

If you’ve already tried to control your debt by yourself and are finding it impossible, debt relief is the next logical step.

Relief through Debt Management Plans

The simplest form of debt relief is debt management. Debt management is a combination of budgeting, financial planning, and negotiation with creditors to create an affordable repayment plan for you.

You can attempt to create your own debt management plan, but usually, the superior option is to work with a non-profit credit counselor.

They’re cheap and trustworthy and already have systems in place to quickly create plans that are beneficial to all parties.

Advantages of Debt Management Plans

Debt management plans are the least drastic debt relief option and probably the strategy you should consider first because:

  • It’s the least harmful to your credit
  • It’s the simplest to implement
  • You don’t need to qualify for any new debt (like consolidation loans or balance transfer cards)

If you choose to use a credit counselor, it can also discourage aggressive lenders from contacting you. They serve as a middle-man, which can take some of the pressure off of you.

Disadvantages of Debt Management Plans

Unfortunately, debt management might not always be enough to control your debt if you have balances that are far beyond your ability to afford.

For example, if you’ve recently lost your only source of income or had to pay for an expensive medical emergency, it won’t be able to do much to solve your issue.

Relief through Debt Consolidation Loans

Debt consolidation is the combination of multiple debt payments into a single payment with better terms.

Traditionally, debt consolidation is accomplished with low-interest consolidation loans. You’d use the proceeds to pay off all your other creditors, then pay back the new (hopefully cheaper) debt in fixed monthly installments.

A slightly riskier alternative is to use a balance-transfer credit card. You can transfer your balances to the new account, which will have a short period (usually around two years) of zero interest accrual, followed by a sharp rate increase.

Advantages of Debt Consolidation Loans

Debt consolidation works best when you’re feeling overwhelmed by the sheer number of your debt accounts, and you think you can get a lower interest rate. It allows you to pay off all of your old lenders and worry about a single payment, ideally with a loan that will:

  • Reduce your total interest costs
  • Lower your monthly payment
  • Have a more favorable payoff schedule

Disadvantages of Debt Consolidation Loans

Unlike debt management (which doesn’t involve opening any new accounts), debt consolidation requires you to apply for a new loan or credit card.

A complete refinance allows you to significantly improve your repayment terms, but it also comes with a couple of drawbacks:

  • It can lower your credit score: Whenever you apply for new credit, lenders make a hard inquiry on your credit history. Inquiries account for 10% of your credit score, so applying for a consolidation loan or balance-transfer card can cost you a few points initially.
  • It’s harder to qualify for: Debt management programs generally don’t require that you meet a credit standard, but any new creditor is going to be wary of lending to you if your score is poor. If you can’t convince someone to lend to you, you won’t be able to consolidate your debt.

Relief through Debt Settlement Plans

If your debt balances have grown so big that you can’t pay them back, debt settlement might sound appealing to you.

You can negotiate with creditors directly or hire a professional to do it for you, but the goal of the plan is to settle your debt for a smaller amount than you owe. This usually means you’ll have to pay a lump-sum, but occasionally you can negotiate to lower your monthly payments.

This option is for debtors who have no hope of ever making it out of debt with less aggressive methods and will have to consider bankruptcy if their creditors don’t strike a deal.

The threat of bankruptcy is your primary negotiating tactic in this scenario because if you declare bankruptcy, unsecured creditors won’t be able to collect anything from you.

Advantages of Debt Settlement Plans

The obvious advantage of a debt settlement plan is that it can drastically reduce the amount you have to pay. Generally, debt settlement companies will try to settle your debt for somewhere between 10% and 50% of the original balance.

Debt settlement plans are also usually the fastest way to become debt-free. Debt consolidation and debt management both require you to follow a long-term payment plan, while debt settlement is over after your one-time lump-sum.

Disadvantages of Debt Settlement Plans

Debt settlement is essentially debt forgiveness, and you won’t get it for free. First and foremost, it’s going to be pretty rough on your credit score for a couple of reasons:

  • A record of the debt settlement will be reported on your credit history
  • You’ll probably have to stop making payments toward your debt for a while

To qualify for debt settlement, you have to demonstrate to your creditors that your settlement offer is the most they can reasonably expect to collect from you.

When you work with a debt settlement company, they’ll have you stop making payments (if you still are) and start setting that cash aside to put toward your lump-sum.

Your payment history is worth 35% of your credit score, so this process can significantly damage your credit.

Additionally, if you don’t qualify for the insolvency exemption, any debt that you have forgiven will be considered income by the IRS, and you can be sure they’ll expect you to pay tax on it.

Relief through Bankruptcy

Bankruptcy is typically the last resort for getting out of debt. Don’t consider it lightly, but if you’ve exhausted all other methods with no success, it’s a viable last-ditch option.

While debt settlement has the potential to reduce your total debt repayments, bankruptcy can essentially eliminate all of your unsecured debt.

For individuals, there are two common types of bankruptcy:

  • Chapter 7: You liquidate all of your non-exempt assets and use them to pay your creditors as much as possible. Your primary residence, personal possessions, and vehicle (within reason) are all exempt from liquidation.
  • Chapter 13: If you earn too much to qualify (over $12,475 monthly) for Chapter 7, Chapter 13 allows you to create an affordable debt repayment plan. Typically, these plans are for installments over the next three to five years. Unlike Chapter 7, it doesn’t require you to liquidate your assets.

Advantages of Bankruptcy

Bankruptcy offers you a clean slate. Most (if not all) of your debts will be forgiven.

Chapter 7 allows you to erase almost all of your unsecured debts, and if you don’t have any assets to liquidate, you can pay next to nothing to your creditors.

Chapter 13 might not save you quite as much, but it does protect your assets from liquidation. But because it’s reserved for high-wage earners anyway, it usually works out in the debtor’s favor to opt for a payment plan.

Disadvantages of Bankruptcy

Unfortunately, bankruptcy will cripple your credit score for a long time. Usually, it will knock you down to somewhere in the mid to low 500s, which can make it extremely difficult to qualify for any sort of financing. You’ll struggle to buy a house, get an auto loan, or even qualify for a credit card.

Generally, Chapter 7 bankruptcy will hurt your credit more. Because it’s usually the better deal for the debtor (you can essentially pay nothing if you have no assets), the credit system naturally disincentivizes it.

Chapter 7 bankruptcy will stay on your record for a full decade, while Chapter 13 will only remain on your record for 7 years.

Which Strategy is Right for You?

Everyone’s circumstances are different, and there isn’t a single debt relief plan that works for everyone. But in general, you should try them in the order of the list above.

Never let a bankruptcy lawyer pressure you into declaring Chapter 7 bankruptcy and paying their fees when a simple consolidation loan would’ve done the trick.

Now we’d like to hear from you. Are you considering debt relief? Contact us today to try out our free consultation.

Maybe you have another debt repayment strategy that you’ve used to escape the debt trap? Let us know in the comments below!

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