There may not be two more widely misunderstood concepts amongst the general public than the concepts of “bankruptcy” and “debt settlement." However, before weighing the pros and cons of each, it is important to first lay out some parameters for the discussion:
- When discussing bankruptcy in this post, I am speaking only of a Chapter 7 bankruptcy. This is the type of bankruptcy in which unsecured debts (like credit cards) are liquidated and eliminated without any payment from ongoing income.
- In discussing “debt settlement,” I am NOT speaking of the companies that you hear advertising all day long that take your money and make payments to the credit cards companies after taking an exorbitant fee and promising things that they cannot deliver. In this discussion, I am speaking only of a scenario in which you work directly with a creditor in an attempt to make a payment arrangement that is outside of the contractual limits. A good example is an individual who makes a lump sum payment of $2,500 to settle a $6,000 credit card debt.
Choosing Debt Settlement
So, with those assumptions, let’s first look at the benefits and drawbacks of settling a debt outside of a bankruptcy case. This can be done best by taking a very common example and breaking it down.
John owes $10,000 on a credit card to ABC Bank. He doesn’t think he is going to be able to keep up with the payments and wishes to attempt to work something out with the Bank.
First, in almost all cases, the bank will not work with you unless you are already delinquent with payment. Why is that? The banks do not believe that there is any incentive to take less than what they are owed if the payments are actually being made.
Next, a bank will almost never make long term payment arrangements at a reduced rate and a reduced payment amount. Again, why is that? Because the banks have been burned so many times by making these deals and not getting the negotiated payments, that all that has been accomplished on their end is a delay in getting the debt to a lawyer who can file a lawsuit.
What Can Be Done?
So, getting back to the above example, what can John do to get this debt taken care of? Well, the one thing that most banks will accept is a lump sum payment in satisfaction of larger debt. So, once John becomes delinquent in payment, John could offer $4,000 to settle the $10,000 balance.
Will the bank accept this? They very well might. Generally, banks are willing to settle a balance for someone between 40% and 60% of what is owed. John needs to be very wary though. There are some hidden problems that can arise from what seems like a really great deal.
What are these hidden problems? Check out Part 2 of Bankruptcy vs. Debt Settlement.