Bankruptcy vs. Debt Consolidation

What is bankruptcy?

Bankruptcy is a legal process that can help you recover from heavy debts by absolving your responsibility to pay them off. While not all types of debt are covered in the bankruptcy process, most consumer debt like credit cards, personal loans and medical bills are discharged.

That means you no longer have the burden of figuring out how to pay those debts when you don’t have the income to cover them. Once debts are discharged, creditors will no longer contact you with collection attempts.

Pros and cons of bankruptcy

Bankruptcy is generally considered a last resort for those experiencing uncontrollable debt. While it has some serious drawbacks, bankruptcy in the right situation can provide relief.

How does bankruptcy affect your credit?

Bankruptcy has a significant negative impact on your credit, according to Scott Barna, president at Stretto, a legal services and technology firm. Your credit score can drop significantly — often by 200 points or more — and you may become ineligible for a mortgage for several years, depending on the type of bankruptcy you file.

Depending on the type of bankruptcy you file for, it will remain on your credit report for seven to 10 years. However, you can begin rebuilding your credit after bankruptcy right away and the negative impact will lessen over time.

What are the types of bankruptcy?

Chapter 7, Chapter 13 and Chapter 11 are the most common types of bankruptcy. Your lawyer or a legal representative can help you figure out which is best for your financial situation.

• Chapter 7 bankruptcy involves the liquidation of a debtor’s assets. In this type of bankruptcy filing, a person’s assets are liquidated (i.e., sold off) in order to gather money to repay creditors. Chapter 7 bankruptcy does not involve a repayment plan. This can be a good option for those who have physical assets that can be liquidated but whose income disallows them from successfully completing a repayment plan.
• Chapter 13 bankruptcy is a way for a debtor to work through a repayment plan over a span of three to six years. It’s a good option for those who have stable incomes and want to maintain possession of assets (and, thus, the responsibility to pay for those assets).
• Chapter 11 bankruptcy allows those who don’t qualify for Chapter 13 to reorganize debt, Barna said. “You can catch up on mortgage arrearages, restructure debt on investment property and in most cases, pay pennies on the dollar toward credit card and medical debt. This can be a good option for those with larger debtor estates."

» MORE: Does bankruptcy clear all debt?

What types of debt are not covered under bankruptcy?

The decision to file for bankruptcy requires careful consideration. One of the first factors you’ll want to discuss with your lawyer is the type of debt you have. That’s a crucial step in deciding on bankruptcy vs. debt consolidation because there are several types that won’t be discharged in the bankruptcy process:

• Tax debt: Income or property taxes in arrears are still owed despite a bankruptcy filing.
• Domestic support obligations: Payments like alimony and child support are not erased by bankruptcy.
• Student loans: Recent legislation from the Department of Justice has brought some changes when it comes to discharging student loan debt, according to Barna.

What is debt consolidation?

Debt consolidation combines multiple debts into one, allowing you to focus on a single monthly payment. Most often, according to Ashley Morgan, a bankruptcy attorney in Herndon, Virginia, debt is consolidated onto a single credit card (ideally with a low or 0% interest rate) or a personal loan or HELOC (which stands for “home equity line of credit” and is essentially a second mortgage).

Pros and cons of debt consolidation

Debt consolidation has several advantages, but it’s important to consider all the benefits and drawbacks.

Debt consolidation loans and balance transfer credit cards

If you’re looking at debt consolidation as the answer to your financial woes, you have a few choices. You can opt to apply for a debt consolidation loan or a balance transfer credit card. Each has benefits and drawbacks, but they work similarly: your debt will be consolidated in one place, allowing you to make one payment instead of juggling multiple.

A debt consolidation loan will typically offer a reasonable interest rate that stays consistent during the entire life of the loan as you pay off your debt. When you apply for the loan, you can state how large of a loan you’ll need in order to effectively consolidate all of your debt.

What to know about balance transfer credit cards

A balance transfer credit card can be a useful option for consolidating debt if you have a good credit score. Unlike a debt consolidation loan, these cards often offer a 0% introductory interest rate, significantly reducing the cost of repayment during the promotional period.

But buyer beware: once this introductory period is over, the creditor can add hefty fees for interest owed on the balance still remaining. So, if you choose to put your debt on a balance transfer credit card, your best strategy is to calculate how much you have to pay monthly to eliminate your debt during the introductory period.

Bankruptcy vs. debt consolidation: Which is right for you?

Deciding between bankruptcy and debt consolidation depends on factors like your debt load, DTI ratio and the types of debt you owe. From a credit standpoint, debt consolidation is a better choice than bankruptcy. However, bankruptcy might be a better option in cases where debt is extreme or so far in arrears that catching up seems impossible. Additionally, if you are facing foreclosure, filing for bankruptcy may allow you to keep your home.

If you have a high amount of debt but have maintained a good credit score or have a stable income, debt consolidation is a great way to get a handle on things. Moving all of your debt onto a personal loan or even a balance transfer credit card with a low (or even a 0%) interest rate can accelerate your debt payoff.

Is bankruptcy better than debt consolidation?

Debt consolidation is usually better than bankruptcy for maintaining credit, especially if you have a steady income and can manage your debt with a lower interest rate. However, bankruptcy may be the better choice if your debt is too overwhelming. If you have lost or lack stable income, bankruptcy might also be the best option.

Comparing bankruptcy vs. debt consolidation side by side

» LEARN: How much does it cost to file for bankruptcy?

Alternatives to bankruptcy and debt consolidation

There are a few alternatives to bankruptcy and debt consolidation that can be considered. If you feel bankruptcy is too extreme for your situation, but debt consolidation doesn’t seem like a good option either, you could try working with your creditor on a debt settlement.

Debt settlement

Debt settlement is when you try to settle your debts for a lesser amount. You can negotiate directly with your lenders or you can work with a company that collects monthly payments and negotiates a settlement with creditors on your behalf. Debt settlement has less of a negative impact on your credit than bankruptcy. However, you may incur fees and tax implications that can make debt settlement expensive.

Credit counseling

A credit counseling service can help you come up with a debt consolidation plan that works with your financial situation as a last-ditch effort to avoid filing for bankruptcy. You’ll sit down with a counselor who can help you review your debts, establish a budget and figure out the best path to financial solvency. This is a paid service, and you’ll want to ensure you find a credit counselor you can trust. Check out the National Foundation for Credit Counseling (NFCC) for more resources.

FAQ

The bottom line

Understanding the differences between bankruptcy and debt consolidation can help you choose the best debt management strategy for your situation. Bankruptcy is typically considered the most extreme step, but it can be an effective way to alleviate the weight of unmanageable debt. Debt consolidation may not lower the amount you owe, but it can provide a simpler method of paying off your debts. Consider your options carefully and choose the route that works best for your circumstances.