Choosing Between Debt Consolidation or Bankruptcy
Nearly half of America’s households (43%) carry a balance from month-to-month on their credit cards and, after a pandemic-created pause, the amount they owe is expected to grow again in 2021.
The Federal Reserve says that despite a jump of $12 billion in Q4 of 2020, credit card debt for the entire year still dropped a record $108 billion, finishing the year at $820 billion.
The average family has a balance of $8,090 in credit card debt and that could soar as the economy reopens and consumers get out of the house to do more spending.
Delinquencies – payments that are more than 90 days late – also declined in 2020, much of that having to do with consumers taking advantage of forbearance provided by the CARES Act. The New York Fed said that serious delinquency (more than 90 days late) dropped from 5.32% in 2019 to 4.12% in 2020.
If you’re one of the dinged for delinquent credit card debt, it might be time to get brutally honest with yourself. You’ll need to ponder if you have enough income to fund a debt consolidation plan or whether your finances are so out of whack that the only alternative is to surrender and file bankruptcy.
Struggling with debt is a juggling act and dropping the ball can have serious consequences. Before you decide how to approach your situation, it’s a good idea to take stock. You may have multiple unpaid credit card balances, a student loan and a home loan, each requiring either a fixed or minimum monthly payment.
Make a list of them all and include the balance owed, the required monthly payment and the interest rate. Add up your minimum monthly payments. This exercise will give you a sense of your situation. Though there are an assortment of techniques to reduce debt and make it more manageable, debt consolidation and bankruptcy are two of the most common.
Debt consolidation, which could be accomplished through a nonprofit credit counselor, turns an assortment of unsecured credit card debts into a single, affordable monthly payment that eliminates debt in 3-5 years.
The alternative, bankruptcy, seeks court protection from creditors and can either discharge debt or reduce it with a payment plan that can take up to five years to complete.
What Is Debt Consolidation?
Debt consolidation is a strategy to reduce the interest rate and lower the monthly payment on credit card bills by combining them into a single payment.
There are several ways to accomplish this, including:
- Enrolling in a credit consolidation program through a nonprofit credit counseling agency. The agency will collect monthly payments from you that include a service fee and pay off your creditors in an agreed upon amount until the debt is eliminated.
- Taking out a debt consolidation loan through a bank, credit union or online lender. Typically, there are fees associated with the loan and your credit score will influence the interest rate. If you don’t have at least a good credit score – something above 650 – that interest rate may not be much better than what you’re paying on your credit cards.
- Taking a do-it-yourself approach by contacting your card companies and offering to repay them at a lower interest rate. Creditors don’t have to accept your terms.
Before attempting this, it’s wise to research tactics and techniques, considering the pros and cons. You can use a nonprofit credit counselor to guide you through the process and offer suggestions.
Before picking a method, consider the pluses and minuses:
Pros of Debt Consolidation
Whether you use a nonprofit credit counseling agency or go it alone, the objective is to turn an assortment of bills into a single monthly payment. If the consolidation loan or debt management program has a lower interest rate than the original debt, you can save money and lower payments. Using debt consolidation will maintain your access to credit and if your plan is successful, your credit score should improve.
Cons of Debt Consolidation
Trying to arrange your own repayment plan usually requires a solid credit score. Whatever type of debt consolidation loan you pursue, a good credit score is usually necessary for approval. The higher your score, the lower your interest rate is likely to be. Also remember that paying off a consolidated debt could take several years and will require that you force yourself to rein in spending, especially credit card spending. Finally, before paying off unsecured credit card debt with a home equity loan or line of credit, remember that you’re putting your home at risk. If you don’t make payments on time, the lender could foreclose on your home.
What is Bankruptcy?
After analyzing your debts and income, you may conclude that you are incapable of paying what you owe, even at a lower interest rate or reduced monthly payments. If that’s where you land, bankruptcy might be the only feasible alternative.
Personal bankruptcy takes two forms. Chapter 7 and Chapter 13.
Chapter 7 forces you to sell all assets except those specified as exempt under state law. Exempt items may include your home, clothes, household furnishings, work tools and car. Nonexempt property is sold or surrendered to satisfy the bankruptcy judgment. When that is done, your other debts are discharged.
Chapter 13 works best for those who want to keep certain assets. It requires that you repay non-discharged debts over three to five years, usually through a single monthly payment to an administrator.
Pros of Bankruptcy
You get a fresh financial start. Both types of bankruptcy eliminate unsecured debts and halt foreclosures, repossessions, wage garnishments, debt collection efforts and utility shut offs. Some of your property might be exempt from the process, depending on your state’s laws. Chapter 7 bankruptcy takes only six months to complete. If you are successful, you basically walk away debt free.
Cons of Bankruptcy
Not everyone qualifies for Chapter 7 bankruptcy. You must pass a means test for Chapter 7 (your income must be lower than the median in your state) to be eligible. Some debts, including alimony, child support, taxes and fines, and student loans, aren’t discharged under either form of bankruptcy. Though Chapter 13 bankruptcy allows you to keep your house in some cases, it doesn’t prevent a creditor from seizing it for an unpaid mortgage or lien. Also remember that bankruptcy severely damages you credit score and makes it difficult to borrow money or buy a home for years after the case is resolved.
Is Debt Consolidation or Bankruptcy Right for You?
Debt consolidation can be a good option if it offers a clear path to financial stability. If you fell into debt for a specific reason, like a medical bill, or you lacked financial discipline that you are now committed to maintaining, consolidation is a good alternative. Consolidating your debts and paying on time can improve your credit score in a relatively short time.
By contrast, if you are unable to change the spending habits that landed you in debt, a consolidation plan is unlikely to help and can make your situation worse.
Bankruptcy can be a better option if a consolidation plan is unlikely to free you from debt in five years or is unavailable because your finances don’t allow you to pass the means test.
Bankruptcy eliminates debts but puts a stain on your credit history for 7-to-10 years. It can protect valued assets like your home or a vintage car, but only if you stick to a spending plan. Also, bankruptcy isn’t available to everyone. Chapter 13 sets a limit on how large your debts can be and requires that you have a regular income. Chapter 7 demands that your monthly income is less than the median for a family of your size in your state.
Since the considerations are complicated, it might be best to meet with a nonprofit credit counselor such as InCharge or a bankruptcy attorney to review your situation and weigh the alternatives.
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