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Settlement or bankruptcy

Last resort: Settlement or bankruptcy

If you can't resolve your debt problems and your credit score has plunged because of missed payments, consider two choices: negotiating a debt settlement or filing for bankruptcy.

Settle your debts

These days it's hard to escape the barrage of ads from debt-settlement companies promising to cut deals on your behalf for only a fraction of what you owe. Those companies charge fees that can run into thousands of dollars, much of it due up front. But you can do the negotiating yourself, says Charles Phelan, a former debt-settlement company executive who founded ZipDebt.com. The Web site provides training materials for negotiating a settlement yourself.

Banks are required to write off your account as bad debt after six months of nonpayment. At that point, issuers typically place the account with a collection agency for at least three to six months in hopes of recovering some of the money. The amount banks get dropped by more than half in 2008, to as little as 6 cents on the dollar.

That decline gives issuers more incentive to negotiate with cardholders earlier in the collection process. "In the past, card companies weren't willing to talk about settling a debt for 50 percent of the balance owed until you were 180 days delinquent. But now we're seeing many of them willing to negotiate that kind of settlement only 90 days after the first missed payment," Phelan says.

You'll generally need to be able to come up with a lump-sum payment or a few hefty monthly payments. Phelan says a realistic amount is half of the balance that was due at the time you made your last payment.

Of course, debt settlement, like bankruptcy, is a last resort because of the negatives it comes with: Your account will be closed, your credit rating will be trashed if it's not already, and you'll be hounded by debt-collection calls until you negotiate a settlement. You also could be sued by creditors, though Phelan says that risk is relatively low until after 12 months of nonpayment. If the amount of debt that creditors agree to forgive exceeds $600, you also might owe income tax on it.

Declare bankruptcy

Under Chapter 7 bankruptcy, lenders write off 100 percent of your card debt, usually within 90 days of filing. You're eligible if you meet strict income limits and means tests imposed by bankruptcy law changes in 2005. If your income is above the median for your state, you will probably qualify only for Chapter 13 bankruptcy, which requires that you repay some or all of your debts over three to five years, as ordered by the court.

Bankruptcy can remain on your credit reports for up to 10 years, but credit bureaus usually delete Chapter 13 after seven. You can learn more about both types and find a bankruptcy attorney near you through the American Bankruptcy Institute or the National Association of Consumer Bankruptcy Attorneys.

This article appeared in Consumer Reports Money Adviser.

Posted: June 2009 — Consumer Reports Money Adviser issue: June 2009