Debt Consolidation vs. Bankruptcy

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The average family with credit card debt carries a balance of $8,425, a number that has surged during the country’s recovery from the COVID-19 pandemic. In an inopportune convergence, consumers are getting back to their old charging habits at the same time that inflation has jacked up prices on nearly everything.

If you’re one of those dinged for delinquent credit card debt right now, 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 and most effective.

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. The goal is to eliminate debt in 3-5 years.

The alternative, bankruptcy, seeks court protection from creditors and can either discharge debt altogether or reduce it with a payment plan that can take up to five years to complete.

Debt consolidation vs. bankruptcy: Which is better for you? We’ll dig into both sides of the discussion to provide some guidance.

What Is Debt Consolidation?

A debt consolidation program provides 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 a number of ways to consolidate debt.

  • Debt Management Program: When you enroll in a debt management program, which is also known as a credit consolidation program, a nonprofit credit counseling 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.
  • Debt Consolidation Loans: Taking out a debt consolidation loan through a bank, credit union or online lender should give you a lower interest rate than you’re paying on your credit card balances. If the loan is big enough to cover all your outstanding debt, you can reduce the number of payments you make per month to one. 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 680 – that interest rate may not be much better than what you’re paying on your credit cards. But it is possible to get a debt consolidation loan even for bad credit.
  • Balance Transfer Credit Cards: This involves transferring the balances on your high-interest card (or cards) to another card with a lower (or even zero) interest rate. The issuer of the new card pays off your debt with the original credit card company, and your monthly payments to the new card company cut into the principal you owe rather than the interest you’ve been paying. Once again, a credit score above 680 is usually a qualifying standard for these cards. When they’re right for you, a balance transfer credit card can save you money.
  • Home Equity Loans/Home Equity Lines of Credit (HELOC): With a home equity loan, essentially a second mortgage, you borrow against the equity you have in your home. Your equity is the difference between the current balance on your first mortgage and the market value of your home. You receive a lump sum which you can use to pay off credit card or other debt, and then you make monthly payments on the home equity loan at a fixed interest rate. A HELOC for debt consolidation works like a credit card. You get a line of credit based on your available equity and can draw from it when you need it. You only pay interest on the portion of the line of credit you use rather than that entire sum you might borrow in a home equity loan.
  • Secured Personal Loans: If you can put up the collateral to secure a personal loan from a bank or private lender, it can come at a lower interest rate than you’re paying on your current debts. That will allow you to pay off some of those debts and leave you with a smaller monthly check to write. Remember, though, that the savings account balance or certificates of deposit you used as collateral is at risk if you don’t regularly write those monthly checks.
  • Do-It-Yourself Debt Management: Sometimes it can be worth it to take matters into your own hands by contacting your card companies yourself and offering to repay them at a lower interest rate. But know going in that creditors don’t have to accept your terms in do-it-yourself debt management, so before you attempt it, 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 choosing any of these methods, consider the pluses and minuses.

Pros of Debt Consolidation

Whether you use a nonprofit credit counseling agency or go it alone, a debt consolidation plan can offer a number of advantages.

  • It turns an assortment of bills into a single monthly payment.
  • It lowers the interest rate you’ve been paying on the original debt or debts.
  • It reduces the total amount you’re paying each month, thus saving money.
  • It gives you a definite timeline for eliminating your debt. It usually can be done in 3-5 years.
  • It maintains your access to credit.
  • It improves your credit score.
  • It makes the bill-paying process easier, especially when you consolidate your debt online.

Cons of Debt Consolidation

Debt consolidation doesn’t work for everybody. There are several drawbacks to keep in mind.

  • Your debt won’t just vanish. A debt consolidation just transfers it from one source (or sources) to another.
  • Trying to arrange your own repayment plan usually requires a solid credit score.
  • Whatever type of debt consolidation loan you pursue, a credit score of 680 or above is usually necessary to get a low enough interest rate to make the loan worthwhile. The lower your score, the higher your interest rate is likely to be.
  • Paying off a consolidated debt could take several years. Other methods might get you to a quicker resolution.
  • It will require that you rein in your spending, especially credit card spending.
  • When you’re paying off unsecured credit card debt with a home equity loan or line of credit, you’re putting your home at risk. If you don’t make payments on time, the lender could foreclose on your home.

» More About: Pros and Cons of Debt Consolidation

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.

There are six types of bankruptcy, but 99%  of them take one of two forms: Chapter 7 and Chapter 13.

Either form can give you a second chance to get your finances in order without giving up many of your possessions, including your home and car. One way to look at it: It’s a legal do-over.

Whether you file a Chapter 7 or a Chapter 13 bankruptcy, your effort to get out from under the weight of your debts will be administered by a bankruptcy court rather than by a nonprofit credit counseling agency or a loan officer.

It might be the best solution for you, but in most cases, bankruptcy court is the last resort for people in debt.

Chapter 7 Bankruptcy

A Chapter 7 bankruptcy forces you to allow a bankruptcy court trustee to sell all your assets except those specified as exempt under your state’s law. You could lose possessions such as jewelry, electronics, stamp (or other) collections, musical instruments and other items that have sellable value. The proceeds from those sales go to pay off your creditors. That’s the bad news.

The good news is that exempt items may include your home, clothes, household furnishings, work tools and car. You can keep almost everything you need to continue to live and work. In fact, the American Bankruptcy Institute says that 94% of Chapter 7 filings are considered “no asset” cases, meaning the trustee doesn’t believe there is enough value to sell off the assets.

When the trustee has finished selling your non-exempt assets and sent the proceeds to your creditors, your unsecured debts such as credit cards, personal loans and medical bills are discharged.

Obviously, there are upsides to a Chapter 7 bankruptcy.

  • As soon as you file for Chapter 7, creditors must stop any lawsuits or collection actions. They can’t even harass you with phone calls.
  • The entire process, from start to finish, usually only takes 6-8 months.
  • You can keep most of what you need to live and work.
  • It almost always is successful. People who are represented by an attorney win their Chapter 7 cases 99% of the time.
  • As soon as your case is completed, you can begin the process of recovering from the credit score hit you took when you filed for bankruptcy.

There are downsides to Chapter 7, too.

  • Not everyone is eligible to file a Chapter 7 bankruptcy. If your household income is more than your state’s median income, you might not qualify.
  • A Chapter 7 bankruptcy will stay on your credit report for 10 years.
  • It might not save you from all of your debts. It won’t help you with alimony and child support, tax liens, student loans and personal injury debts.
  • You might lose some of your prized possessions if they aren’t exempt. The court will sell luxury items such as jewelry, a second car, a vacation home or other items you don’t need to subsist.
  • It isn’t free. Filing costs $338 in court fees.
  • Once you’ve filed a Chapter 7, you must wait eight years before you can file another one, and four years before you can file a Chapter 13.

Chapter 13 Bankruptcy

Chapter 13 requires that you stick to a court-approved plan in which you make a single monthly payment to a trustee to pay down your debts. The repayment plan lasts from 3-5 years. At the end of that period, any unsecured debts such as credit cards are discharged.

To be approved for a Chapter 13 bankruptcy, you must have a regular income to make the monthly payments.

There are advantages to filing for Chapter 13.

  • As long as you make the regular monthly payments under the court-approved plan, you keep your house, your car and other property.
  • It gives you time and flexibility to repay your creditors. Most repayment plans cover 3-5 years, time that can be used to catch up on missed mortgage bills or other secured debt.
  • In some Chapter 13 cases, your creditors might not be entitled to the full amount of what you owe, which means the size of your debt can be reduced.
  • While you’re in Chapter 13, you can stop missed payments and other defaults from appearing on your credit report.

There are, of course, disadvantages to a Chapter 13 filing.

  • That 3-5 year repayment plan can feel like a long time.
  • A Chapter 13 bankruptcy stays on your credit report for seven years.
  • Your monthly payments come out of your disposable income, which is what’s left after you’ve paid for life’s necessities. You might find you don’t have much extra cash on hand.
  • If you don’t keep up with the court-approved repayment plan, the case will be denied.
  • As with Chapter 7, your Chapter 13 case won’t relieve you of alimony or child support, or your student loan debt.
  • To be eligible to file for Chapter 13, you must have less than $395,725 in unsecured debt, or less than $1.184 million in secured debt.
  • Court fees for a Chapter 13 filing are $313.

Pros of Bankruptcy

  • You get a fresh financial start.
  • Both types of personal bankruptcy, when successful, eliminate unsecured debts and halt foreclosures, repossessions, wage garnishments, debt collection efforts and utility shut offs.
  • Some or most of your possessions might be exempt from the process, depending on your state’s laws.
  • Chapter 7 bankruptcy usually takes only six months to complete. If you are successful, you basically walk away debt-free.

 Cons of Bankruptcy

  • Not everyone qualifies. You must pass a bankruptcy means test for Chapter 7, meaning your income must be lower than the median in your state to be eligible. And for Chapter 13, there are limits on how much debt you are carrying 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.
  • Bankruptcy severely damages your credit score and makes it difficult to borrow money or buy a home for years after the case is resolved.

How Do Debt Consolidation and Bankruptcy Impact Your Credit?

A debt consolidation can actually improve your credit score, while bankruptcy has a negative impact that stays on your credit report for years.

It makes sense that debt consolidation, which reduces the number of your creditors and lowers your monthly payments, will help your credit score, assuming you continue to meet the required single monthly payment obligation.

Because combining debt payments, even with bad credit, into a consolidation alternative such as a nonprofit debt management program will help you pay off your debt more quickly, your credit score will start to rise.

The start of the program, though, might include a short-term hit to your credit score, thanks to the check into your finances required during the application process. That should only last for a 6-8 months, and the temporary drop in your score shouldn’t be drastic.

There can be small differences in the impact of debt consolidation on your credit, depending on which type you choose. For example, when a plan requires you to cancel a card, it reduces the amount of your available credit, which in turn can reduce your credit score.

Regardless of the debt consolidation plan you choose, though, your credit score will rise in the long run if you regularly make your payments on time. It’s worth remembering that 35% of your credit score is determined by your payment history.

Bankruptcy’s negative impact on your credit, on the other hand, can be dramatic. A study by FICO, the major player in the credit scoring industry, found that filing for bankruptcy can cause a drop of at least 200 points in a credit score that had previously been in the good range (700 or above). The effect on a low credit score isn’t as significant, but bankruptcy nonetheless will cause a drop.

Because you aren’t making payments to your creditors in a Chapter 7 filing, that type of bankruptcy is harder on your credit score than a Chapter 13 filing is. A Chapter 7 bankruptcy stays on your credit report for 10 years, while a Chapter 13 filing stays on your report for seven years.

In either case, bankruptcy will make it difficult to get credit on reasonable terms. Though you can begin the process of improving your credit rating as soon as the bankruptcy is finished, it likely will take time (and a history of on-time payments) before you get it back to where you want it.

Alternatives to Debt Consolidation and Bankruptcy

Before you dive into either debt consolidation or a bankruptcy filing, it’s worth investigating the other options for finding your way out from under a mountain of credit card debt. Depending on your financial situation, you might find better, and less painful, alternatives.

There are a number of avenues to consider.

  • Credit Counseling: Sometimes called debt counseling, this option is free of charge and includes a review of all the available options for tackling debt. A certified credit counselor from a nonprofit credit counseling agency examines your income and expenses, reviews your credit report and helps you develop a personalized plan to solve your money problems. It’s a very useful first step on the road to solving your money problems.
  • Debt Management Program (DMP): This is a plan that reduces the interest rate you’re paying on your credit card debt to around 8%. The average interest rate on credit cards in August 2022 is just over 19%, and it jumps significantly when you are missing payments. A counselor at a nonprofit agency such as InCharge Debt Solutions personalizes a DMP based on your income and expenses to arrive at a monthly payment you can afford. It can eliminate your debt in 3-5 years, and your current credit score isn’t a factor in getting into the program.
  • Debt Settlement: In debt settlement, you (or a company you hire) negotiates with a lender or collection agency on a new payment amount for the debt you owe. Once both sides agree on the new amount, you start saving for it so you can pay it off in a lump sum after 2-3 years. You end up paying less than what you owed, but debt settlement appears on your credit report for seven years. It can lower your credit score by 100-200 points.
  • Budgeting: A ledger of income vs. expenses, a budget helps you with the spending decisions you want and need to make. It estimates how much money you’ll take in over a period of time into the future, and measures that against how much you’ll need to cover your bills and pay for life’s necessities such as food and housing. Because budgeting shows you how much you spend against how much you make, it’s perhaps the simplest and most effective way of managing or avoiding credit card debt.

Is Debt Consolidation or Bankruptcy Right for You?

The state of your finances should be the determining factor as you weigh the choice between debt consolidation and bankruptcy. If you realize you are carrying too much debt and a consolidation plan is unlikely to free you from it in five years, bankruptcy as a last resort might be the better option.

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.

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.

Speak With a Credit Counselor to Discuss Debt Relief Options

A mammoth credit card debt does more than just drag down your finances. It can affect your psychological well-being, too. Study after study has found a strong connection between months of unpaid balances and dangerous stress levels along with other negative mental health ramifications.

When it becomes too much, it’s important to get help with your debt. But you want to be sure you address the problem with the relief option that best fits your specific financial predicament. Since the considerations are complicated, it might be best to meet with a certified credit counselor at a nonprofit agency such as InCharge. Even an initial 30-minute consultation, which is free and can be done over the phone or online, can start you toward a plan that helps you regain control of your finances.

An InCharge credit counseling session offers a budget review with personalized suggestions about cutting expenses, an analysis of the debt accounts in your credit report, and recommendations for an action plan (and alternatives) to solve your debt problem. The credit counselor will help you understand the ways in which a debt consolidation or a bankruptcy filing fit, or don’t fit, your particular financial circumstances.

About The Author

Michael Knisley

Michael Knisley writes about managing your personal finances for InCharge Debt Solutions. He was an assistant professor on the faculty at the prestigious University of Missouri School of Journalism and has more than 40 years of experience editing and writing about business, sports and the spectrum of issues affecting consumers and fans. During his career, Michael has won awards from the New York Press Club, the Online News Association, the Military Reporters and Editors Association, the Associated Press Sports Editors and the Sports Emmys.


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