Debt Consolidation vs Bankruptcy: Which is Best for Me?
If you’re struggling with debt and can’t seem to keep up with your monthly payments, you’ve probably wondered about your best next steps. Would you be better off consolidating debt and trying to pay it off yourself? Are you so bombarded with debt that bankruptcy is the only feasible way out?
Before you make a decision one way or another, it’s important to understand what options are available to you, how they might help you out of debt, and how each solution will work over the long-term.
This guide will help you decide while shedding light on the pros and cons of each strategy.
What is debt consolidation?
Debt consolidation is a term used to describe several different strategies that can help you cope with debt. These strategies can help you accomplish various goals such as lowering your interest rates, lowering your monthly payment, getting back on track with a payment plan, and ultimately paying your own way out of debt.
Types of debt consolidation include:
Debt consolidation loans – A debt consolidation loan can help you merge all your outstanding debts into a single new loan. Ideally, you’ll be able to qualify for a loan with a better interest rate and more manageable monthly payment. However, sometimes people use debt consolidation loans as a way to better manage multiple payments.
A few examples of loans that can help you consolidate existing debt include:
Debt management plans – Debt management plans (DMPs) require you to make a monthly payment to a credit counseling program, which will in turn manage and pay your debts for you. The agency you work with may try to negotiate down your interest rates with your creditors so you’re paying off debt faster. Be careful to only work with a reputable debt management firm. The Federal Trade Commission (FTC) has guidelines to follow here.
Debt settlement programs – Debt settlement programs offer to negotiate with your creditors on your behalf. They may negotiate a lower settlement on your debts than what you owe, helping you save money and get out of debt faster. You should also research any debt settlement programs carefully first and be sure that your lenders are actually willing to negotiate with a third party before you enlist their services.
Qualifying for consolidation
Debt management plans and debt settlement plans were created for people who are struggling to pay their bills and likely have bad credit. Reputable firms will only work with consumers who can benefit from their services. There are no credit score requirements to work with credit counselors. But you’ll have to meet with a credit counselor first to be sure a DMP is the best fit for you. For example, the National Foundation for Credit Counseling requires consumers to schedule a consultation first.
If you’re angling for a debt consolidation loan, on the other hand, you may need a FICO score of at least 600 to qualify. The better your credit score, the more likely you are to qualify for better terms.
The benefits of debt consolidation, versus bankruptcy
If you’re truly drowning in debt and need help to find a solution, consolidating your debt or getting help from a third party may be your best debt. While each type of debt consolidation works differently, each can benefit you by reducing your interest rate, reducing the amounts you owe or making your monthly payments more manageable.
Here are a few benefits:
- Debt consolidation can improve your credit score. Unlike filing for bankruptcy, which can seriously harm your credit score, consolidating your debt and paying it down gradually can improve your score. However, Barry J. Roy, a bankruptcy attorney at the Livingston, N.J., firm Rabinowitz, Lubetkin & Tully LLC notes that there’s a lot of nuance that goes into your credit score. As a result, the final impact of debt consolidation or bankruptcy can depend a lot on your personal situation.
- You’re not putting your personal property at risk with debt consolidation. While consolidating your debts allows you to keep your personal property, the same isn’t always true for bankruptcy, notes Roy. “With bankruptcy, the courts may move to sell your nonexempt personal property depending on your situation,” he says.
- Debt consolidation may be “easier” than bankruptcy. If you don’t have a ton of debt and can get out of debt on your own, consolidating your debt may put less stress on you emotionally and financially. Of course, this depends on how much debt you have and your ability to get on track repaying your loans, says Roy.
- Take responsibility for your debts. While bankruptcy can offer you a way out of debt if you qualify, debt consolidation allows you to take responsibility for your outstanding debts and pay them off yourself – even if you need outside help to negotiate on your behalf.
Debt consolidation risks
While consolidating debt can seem like a simpler option than going through bankruptcy, that doesn’t mean it’s risk-free. Consider these risks before you take steps to consolidate debt or get third-party help with managing your debt load and creditors:
- Help from debt relief services can be costly. According to the FTC, the fees charged by debt relief companies can be extremely costly. Make sure to read the fine print and understand all included fees before you sign up. Check out the name of a debt management company with your state attorney general and local consumer protection agency
- Debt settlement doesn’t always work out in your favor. While a debt settlement company might try its best to negotiate down your debts or interest rates, there’s no guarantee these efforts will work out. In fact, some lenders will not even negotiate with third-party debt relief firms, so you should check with your lender before you hire a firm for nothing.
- Debt settlement can hurt your credit. As the FTC notes, many debt settlement companies will ask you to stop paying your bills until your debts are settled or negotiated. This can cause dramatic damage to your credit score, even if your credit is hurting already.
- Debt consolidation is only a solution if you see it through to the end. According to Roy, many people seek out debt consolidation loans or debt settlement programs without having the ability to finish them out. In those cases, they are often left worse off than they were before. “Debt consolidation only works out if you’re able to fulfill the agreement,” he says. If you default, you could wind up with all your debts plus more outstanding fees than you started with.
What is bankruptcy?
Bankruptcy is a proceeding in federal court that allows a borrower to eliminate or restructure his/her debts. However, it’s important to note that more than one type of bankruptcy exists. Further, not all types of bankruptcy will erase your debts completely.
The type of bankruptcy that might work better for you depends on how many assets you have, your income and how substantial your debts are.
Chapter 7 bankruptcy
A Chapter 7 bankruptcy is often considered the most “complete” type of bankruptcy because it may discharge most or all of your debts. If you qualify for this type of bankruptcy, your debts can be wiped clean so you won’t have to worry about repaying them again.
This type of bankruptcy typically takes four to six months to complete, according to Roy, and will remain on your credit report for a full 10 years.
How to qualify for Chapter 7
Because typically discharges all your debts, it is generally harder to qualify for. For starters, there are income guidelines you have to meet. If you earn too much and cannot pass a “means test,” you may not qualify for Chapter 7 bankruptcy, notes Roy. However, since it’s so complex, only a lawyer can help you determine if your income helps or hurts your case.
You aren’t eligible for Chapter 7 bankruptcy if you’ve received this type of bankruptcy within the last eight years, either. Lastly, you may have to give up any nonexempt property you own as part of the process since the courts will need to seize your assets to repay your creditors.
Chapter 13 bankruptcy
A Chapter 13 bankruptcy works differently because it doesn’t eliminate your debts. Instead, it restructures what you owe and helps you set up a repayment plan.
There are limits on the amount of debt you can restructure with Chapter 13 bankruptcy as well. For example, the total amount of unsecured debt you can file for cannot exceed $394,725 for all of 2017 and 2018.
Chapter 13 bankruptcy also highlights some of your debts as “priority debts.” These debts must be repaid, and typically include expenses like taxes and the costs of bankruptcy proceedings. A second type of debt Chapter 13 bankruptcy highlights is “secured” debt. Secured claims are ones for which the creditor can take back certain property if the debt is not repaid, such as your house or cars.
Unsecured debts are whatever is left over, and can include credit card debt and other unsecured loans.
Generally speaking, your Chapter 13 bankruptcy payments will cover priority debts and secured debts first. After that, you’re required to pay a certain percentage of your “disposable income” toward your unsecured debts. According to the U.S. government, your disposable income is determined using a complex formula that assesses your income, your debt obligations, the number of dependents you have, your monthly expenses, and other criteria.
How to qualify for Chapter 13
To qualify for Chapter 13 bankruptcy, you have to meet certain income requirements. If your income is too low or high, you may not be eligible. Because Chapter 13 bankruptcy lets you keep your property, it is often a better choice for people who have assets or considerable equity in a home, notes Roy.
Benefits of bankruptcy, versus debt consolidation
The benefits of bankruptcy vary depending on how much debt you have and the type of bankruptcy you qualify for. The advantages of bankruptcy over debt consolidation also depend on your personal financial situation and the debts you owe. Here are some potential benefits from bankruptcy to look forward to if you choose this option:
- You could have your debts wiped away completely. According to Roy, the top benefit of bankruptcy is the fact that, if you qualify for Chapter 7 bankruptcy, you may have your debts wiped away completely. This can be a huge advantage if you’ve been emotionally drained by trying to repay your debts and want a way out more than anything else.
- You may not have to repay everything you owe – even with Chapter 13 bankruptcy. While Chapter 13 bankruptcy requires you to repay priority and secured debts if you want to keep your property, you may not have to repay your unsecured debts like credit card debt and medical bills.
- Chapter 13 bankruptcy can help you keep your house. If you have considerable assets or a lot of equity in a home, Chapter 13 bankruptcy can grant you help with your other debts without having to give up your property.
Risks of bankruptcy
While bankruptcy may sound like the answer to your prayers, it, like debt consolidation, is not free of risk. Some potential risks of bankruptcy include:
- You’ll damage your credit score. Chapter 7 bankruptcy stays on your credit report for 10 years, while Chapter 13 stays on your credit report for seven years. Either option will hurt your credit score in the meantime, and may prevent you from qualifying for other loans.
- You may lose your assets. If you file for Chapter 7 bankruptcy, you may need to give up your home and other assets so they can be sold to repay your creditors.
- Income requirements apply. You may not qualify for either form if your income is too high or too low.
- Bankruptcy isn’t free. Any time you hire a lawyer, you’ll need to pay for his or her services. Bankruptcy also comes with legal fees you’ll need to pay out of pocket to move your case forward within the courts.
Which people are best suited to debt consolidation?
If you’re trying to decide between debt consolidation and bankruptcy, it makes sense to determine whether you can manage your debts on your own. The FTC suggests a few different self-help strategies that can help you find the extra money to pay your outstanding bills.
For example, you could start using a budget and look for ways to cut your monthly expenses. You could also call your creditors and try to negotiate your interest rates down on your own.
If you feel these steps could work for you, then debt consolidation may be a better, less drastic first step forward.
Bankruptcy, on the other hand, tends to work better for people who cannot find a manageable way to get out on their own.
Roy offered the example of someone who has so much credit card debt that it would take them decades to pay it off. Of course, different types of bankruptcy — Chapter 7 and Chapter 13 — work better for different people based on their financial situation.
“Chapter 7 bankruptcy is best for consumers who have significant credit card debt when compared to their income, especially if they are now only able to make minimum payments,” notes Roy. Chapter 13, on the other hand, works for folks “who have fallen behind on their bills either due to illness or loss of income, but have equity in their home or another significant asset that they want to protect.”
If you’re drowning in debt and cannot see any way you could pay it off on your own, Chapter 7 or Chapter 13 bankruptcy could be the only solution that makes sense.
How to declare bankruptcy
Before you declare bankruptcy, you are required to meet with a non-profit debt counselor first. This counselor can help you determine if your debts are truly insurmountable, or if bankruptcy is really the only way out. To get started on this first step, you can find a list of the approved agencies here.
Once you determine you are a good candidate for bankruptcy, you’ll need to meet with a lawyer who specializes in bankruptcy law. A lawyer can help you determine which type of bankruptcy you qualify for and how to proceed while minimizing out-of-pocket costs and financial harm.
How to consolidate your debt
If you’re leaning toward consolidating your debt, your first step is sitting down to figure out how much debt you have. Tally up all your outstanding loans and bills, along with how much you owe each month.
From there, you need to determine whether a debt consolidation loan might work or if you need the help of a debt management or settlement company. Generally speaking, a debt consolidation loan may be better if you have fewer outstanding debts and feel you can pay it all off yourself.
Should you consolidate debt or use bankruptcy to (hopefully) wipe it all away? At the end of the day, only you can decide. To get started, take a closer look at all your debts and monthly payments. Figure out how much you owe every month and weigh it against your income. If your monthly payments should be manageable, then you may just need to get on a monthly budget or cut your spending to get back on track.
If your debts are out of control, on the other hand, then bankruptcy might be the only option to consider. As always, you should make sure you understand the fine print, costs and risks. That way, any decision you make is sure to be an informed one.