Debt Consolidation
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Debt Consolidation vs. Bankruptcy: Which Is Right for You?

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If you’re struggling to manage your debts, you might be weighing your financial options. When it comes to debt consolidation versus bankruptcy, it’s crucial to understand the differences between these two approaches, as well as the pros and cons of each.

Debt consolidation involves taking out a new loan or line of credit to repay your debt under new, potentially more favorable terms. Bankruptcy, on the other hand, can wipe away or reduce your debt, but it will also damage your credit score for years to come.

What is debt consolidation? The basics

Debt consolidation is a process of paying off multiple debts from a variety of lenders with a single new loan or line of credit. Debt consolidation loans, a particular type of personal loan, are commonly used to consolidate debt, and they generally don’t require collateral. Ideally, the new debt will have a lower interest rate than the debts being consolidated under it, which can help lower your overall cost of repayment.

You don’t need a specific debt consolidation loan to consolidate debt. Here are some other common financial products you can use for this:

  • Balance transfer card: This can be a good solution for consolidating revolving debt. With this method, you transfer all of your individual credit card balances to a new card with a lower interest rate or a no-interest introductory period. However, you’ll need to repay your balance in full during the introductory period (usually 12 to 21 months) to avoid being charged interest on your remaining balance.
  • Secured personal loan: Some lenders offer personal loans that are secured by underlying collateral, such as existing certificates of deposit or savings account balances. These loans may offer lower interest rates than unsecured personal loans and be easier to qualify for, but they do put the collateral assets at risk if you fall behind on payments.
  • Home equity loan: The difference between what your home is worth and what you owe on the mortgage is the home’s equity. You may be able to get a home equity loan for a portion of this amount and use it to pay down debt. This can secure you a lower interest rate on your debt, though it also puts your home at risk if you struggle to pay your bill.
  • Home equity line of credit (HELOC). Like a home equity loan, a HELOC allows you to borrow against your home equity. But instead of borrowing a fixed amount in a single check, you get an open, revolving line of credit that you can access for a set period. HELOCs also have an adjustable interest rate; this can be dangerous in an environment where rates are rising, as your cost to borrow will likewise increase.

Who debt consolidation may be best for

  • Individuals who are able to pay back their debts: While bankruptcy can clear away some of your debts, consolidation involves paying it back under new terms while protecting your credit.
  • Consumers with a diverse amount of credit cards and debt: The goal of debt consolidation is to reduce the interest on your debts and to get multiple debts under a single loan umbrella.
  • Borrowers with good credit: The better your credit, the better your chances of securing a debt consolidation loan. And the higher your credit score, the lower your interest rate is likely to be.
  • Disciplined borrowers making timely payments: Borrowers with on-time payment histories generally have higher credit scores and, thus, can lock in lower interest rates. They will also need to continue making disciplined payments on the personal loan for the duration of its term.

What is bankruptcy? The basics

Chapter 7 bankruptcy

Chapter 7 bankruptcy is a specific method of bankruptcy that results in a debtor’s nonexempt assets being sold to pay off existing debts. If there are no assets, or the asset value does not equal the total debt, it still clears the slate.

Who Chapter 7 bankruptcy may be best for

  • Those who can pass the means test: The goal of the means test is to ensure that people who have the ability to repay their debt aren’t able to file Chapter 7. If your disposable income is too high, then Chapter 7 is not an option that is available to you.
  • People with no assets to protect: Chapter 7 bankruptcy limits the types of assets you can protect from liquidation. Those with second homes, multiple cars, boats and other nonexempt assets may want to avoid filing Chapter 7 if they want to retain these assets.
  • Borrowers who are already significantly behind in paying bills: Bankruptcy can negatively impact credit for up to 10 years. Those who are already behind in paying bills may have less to lose, as their credit scores are likely already low.
  • Consumers whose debt is primarily from dischargeable debts: Not all debts are discharged during bankruptcy. Individuals with certain tax debts, past-due child support, alimony debts and other nondischargeable debts might want to find an alternative solution.

Chapter 13 bankruptcy

With Chapter 13 bankruptcy, the goal is to reorganize the debt through a three-to-five year payment plan. This results in reduced overall debt while allowing a borrower to retain ownership of assets. Chapter 13 bankruptcy can stay on credit reports for up to seven years.

Who Chapter 13 bankruptcy may be best for

  • Borrowers who can afford three to five years of payments: To get a Chapter 13 bankruptcy approved, a borrower must propose a reasonable payment plan for the next three to five years. The net payment may be less than the overall debt, but it needs to meet the court’s requirements and must be maintained.
  • Those who have assets to protect: Because there isn’t a liquidation of nonexempt assets in a Chapter 13 bankruptcy, it works well for those who have assets they want to protect.
  • Individuals who do not qualify for Chapter 7: When a borrower fails the means test or doesn’t qualify for Chapter 7 for another reason, Chapter 13 might be a suitable alternative.
  • Consumers with debt that doesn’t exceed limits: Chapter 13 is limited to borrowers who have no more than $394,725 of unsecured debt or $1,184,200 of secured debt.

Debt consolidation vs. bankruptcy: Pros and cons

While debt consolidation means combining your debts into a new loan with new repayment terms, bankruptcy involves discharging or reducing it so you no longer have to pay back some of it (or even all of it).

There are a few ways to consolidate debt: You could use a personal loan, balance transfer credit card or home equity loan, for example. Most debt consolidation strategies require that you have good credit to qualify.

Bankruptcy, on the other hand, is typically considered a last resort for consumers who don’t have the means to pay back their debts. While it can be a useful strategy in some circumstances, it can also cause long-lasting damage to your credit.

Debt consolidationChapter 7 bankruptcyChapter 13 bankruptcy
How it worksCombines multiple debts with a single, new loan or line of creditCourt-supervised sale of a debtor’s assets to pay off existing debtsCourt-approved, 3- to 5-year debt reorganization plan
Pros

  Consolidation loans are often unsecured

  Process protects credit score

  Can reduce overall interest paid

  Reduces number of monthly payments

  Removes all dischargeable debt without further payment

  Can stop collections, foreclosures and garnishments

  Often completed within months

  Often reduces total debt balances

  Shortens repayment term

  Can stop collections, foreclosures and garnishments

Cons

  Requires ongoing payments

  Might not be a workable option for those with lower credit scores

  Could require collateral

  Negatively impacts credit (up to 10 years)

  Must qualify through means testing

  Nonexempt assets can be liquidated

  Negatively impacts credit (up to 7 years)

  Borrowers can’t exceed debt limits

  Takes at least 3 years to pay off

Bankruptcy or debt consolidation: How each can affect your credit

Debt consolidation typically won’t impact your credit much. While you may need to go through a hard credit check for a debt consolidation loan, which can put a dent in your credit score, this is typically temporary. In fact, your credit score may even improve more quickly as you consolidate your debt and pay it off faster.

Bankruptcy, however, typically impacts your credit score negatively for a while. Chapter 7 bankruptcy usually stays on your credit score for about 10 years once you’ve filed, while Chapter 13 remains for 7 years. However, after your debts are discharged, you can start to rebuild your credit and bring it back up again.

Bankruptcy or debt consolidation: How to decide which is better

When determining whether to choose bankruptcy or debt consolidation, each borrower’s individual financial situation will be the dominating consideration. Some of the factors to consider include:

  • Credit score: Individuals with a higher credit score can benefit from more competitive terms on a debt consolidation loan.
  • Income predictability: Individuals with unpredictable income and potential for job loss might be better suited to Chapter 7 bankruptcy, if they qualify.
  • Amount of debt: Consolidated debt must still be paid back, so if the debt burden is too high, then a Chapter 7 (wipes out dischargeable debt) or a Chapter 13 (reduces debt) filing might be better options.
  • Overall financial health: Debt consolidation works well for those in stable financial situations. But if you’re buried in debt and can’t find any other reasonable path out, bankruptcy may be an option worth exploring.

Generally speaking, debt consolidation is a preferable option if you can qualify for a lower interest rate than you have currently on your debts, and if you expect your financial situation to improve in the future. If you’re not able to pay back your debt consolidation loan, it won’t help very much, and could even hurt your credit if you miss payments.

If you’re completely overwhelmed by debt and know that you wouldn’t have the means to pay back consolidated debt, it may be worth considering bankruptcy. However, the rules around bankruptcy are complicated, so consulting a lawyer or counselor before you make a move may be wise. Plus, it’s important to understand the long-term consequences of filing for bankruptcy before you commit.

When comparing debt consolidation versus bankruptcy, it’s also worth noting that these aren’t your only options for dealing with debt.

Other debt management options you may consider

Debt management options aren’t limited to debt consolidation and bankruptcy. Other steps you can take to manage your debt include:

  • Debt management plan: A nonprofit debt management plan run by a credit counseling agency can give borrowers financial counseling and may help get their finance charges and fees reduced. Through this type of plan, the borrower makes a single payment each month to the agency, and the agency then makes payment directly to creditors. Note that these plans do come with additional fees.
  • Debt settlement plan: Debt settlement companies are for-profit enterprises that claim to negotiate lower debt balances in exchange for lump-sum payments made by the borrowers. For this process to work, borrowers must generally remain delinquent with their creditors for a significant period of time and must have access to funds that can pay the lump-sum amount and settlement company fees. However, in addition to destroying your credit, there’s no guarantee that the settlement company will work out an affordable agreement with your creditors. (You can, however, attempt to settle on your own.)
  • Creditor negotiation: In many cases, consumers can call their creditors and work out deals themselves to reduce outstanding balances, remove fees and even reduce interest amounts.
  • Debt payoff planners: Budgeting programs and apps can help a borrower prioritize spending to ensure they pay off debt. When these are used to accelerate repayment terms, it also reduces the interest paid. Still, this option is only viable to those who have the income and ability to make extra payments or adjust payments.

Carrying debt for decades isn’t something most people look forward to. Either bankruptcy or debt consolidation could be a solution, depending on your debt, finances and objectives. If you are facing insurmountable debt, these additional strategies can also help.

 

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