Debt Consolidation

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

Many Americans struggle to balance their debt load with their monthly living expenses. Options like debt consolidation and bankruptcy can make it possible to overcome seemingly insurmountable debt.

But there are vast differences between these two options. For one, debt consolidation may require good credit to make it worthwhile, and bankruptcy can badly damage your credit for several years in exchange for providing debt relief.

Debt consolidation vs. bankruptcy: Pros and cons
Which is better: Bankruptcy or debt consolidation?
Other debt management options you may consider

Debt consolidation vs. bankruptcy: Pros and cons

Debt consolidation Chapter 7 bankruptcy Chapter 13 bankruptcy
How it works Combining multiple debts with a single, new loan or line of credit Court-supervised sale of a debtor’s assets to pay off existing debts Court-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
  • Done 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
  • Must qualify through means testing
  • Nonexempt assets can be liquidated
  • Negatively impacts credit
  • Borrowers can’t exceed debt limits
  • Takes at least 3 years

Debt consolidation

Debt consolidation is a process of paying off multiple debts with 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. This helps lower your overall cost of repayment.

But you don’t need a debt consolidation loan to consolidate debt. Here are 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. You’ll need to repay your balance in full during the introductory period (usually 12 to 18 months) to avoid being charged deferred interest, however.
  • 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 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 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, but it also puts your home at risk if you struggle to pay your bill. (Learn more about home equity loans here.)
  • 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

  • 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.

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 asset value does not equal the total debt, it clears the slate regardless.

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 isn’t going to work for 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.

Who Chapter 13 bankruptcy may be best for

  • Borrowers who can afford 3 to 5 years of payments: To get a Chapter 13 bankruptcy approved, a borrower must propose a reasonable payment plan for the next 3 to 5 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, 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.

Which is better: Bankruptcy or debt consolidation?

When determining whether to choose bankruptcy or debt consolidation, each borrower’s individual financial situation will be a 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.

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 will help borrowers get financial counseling and may have their finance charges and fees reduced. Through this 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 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 as well as the settlement company fees. In addition to destroying your credit, there are no guarantees 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. 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, your finances and your objectives.

 

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