Bankruptcy's Credit Damage Worse than Debt Settlement's

By Jane McNamaraLifestyle and

Dear Let's Talk Credit,

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I was out of work for a few years and my credit cards went unpaid. I am to the point now where they sent me a compromise to pay less. I only owe a total of $13,000. Is this better for my credit than claiming bankruptcy? 

- Mike

Dear Mike,

The short answer to your question is bankruptcy will damage your credit more than settling your credit card debt. Let's explore your options in a little more detail.

When considering a settlement offer, you need to be sure you can afford the payment that the creditor is requesting. Another thing to keep in mind is that the IRS considers forgiven debt as taxable income when it is $600 or more. So, if you owe $13,000 and agree to settle your debt for $5,000, the $8,000 that is forgiven would be considered income for the tax year that it is forgiven. Depending on your income tax bracket, you could owe an additional $1,000 to $2,000 in taxes.

As far as how a settlement will affect your credit, the majority of damage to your credit history was done when the credit cards went unpaid. Creditors like to see that you did eventually pay what you owe, even if you pay only a portion of the total amount due. In addition, with a settlement, the accounts will drop from your credit report seven years from the date of last delinquency. So, if the accounts are already three years old, you would have only four years or so before they no longer affect your credit.

Filing bankruptcy could cause more damage to your credit and for a longer period of time. A Chapter 7 remains on your credit report for 10 years from the date of filing and a Chapter 13 remains on your report for seven years from the date of filing. Creditors may view you as more of a credit risk with a previous bankruptcy on your credit as opposed to a debt settlement.

Depending on your income level, you might not qualify for a Chapter 7 liquidation. Filing a Chapter 13 would require you to repay some portion of your debt. To qualify for a Chapter 7 filing in most cases your income must be lower than the median income for your state.

Another thing to consider is the cost involved with filing for bankruptcy and any attorney fees.

Whatever you decide to do about your old credit card debt, your credit will improve with time and as you add positive information to your credit report each month.

Let's keep talking!

See related: 14 factors when considering bankruptcy, How debt settlement works, how it affects scores