If you have debt in America, you’re not alone. Research shows that about 77% of Americans are caught up in the chains of debt. That’s almost eight people out of the ten you come across while walking in the streets. Today we discuss the differences between debt consolidation vs bankruptcy to decide which is better depending on your personal finance situation.
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Whether it’s paying for your newly acquired car or financing your mortgage house, debt happens and can quickly lead to hard-to-manage and high-interest loans. And while this can sometimes be inevitable, it’s how you choose to handle your loans that counts.
If you’re looking for the best path out of overwhelming debts, you may be wondering which is better between bankruptcy vs debt consolidation. This post compares these two debt relief solutions and gives a verdict on the best of the two.
Let’s get started!
What is Debt Consolidation?
Debt consolidation is a debt relief plan that involves combining multiple debts into one loan or credit card – often to minimize the interest rates and the number of payments.
If you’re struggling with credit card debt, or several loans such as student loan debt and a medical bill, debt consolidation allows you to merge them into one loan. This means that you’ll have only one monthly payment to make instead of the several you might be juggling. Even better, the monthly payment may be lower than the sum of all of your old payments.
Here are a few lines of credit you can use to consolidate your debts:
- Personal loan: Perhaps the best option, a personal loan for debt consolidation almost always has lower interest rates than credit cards, meaning you save a lot.
- Balance transfer credit card: Although riskier than personal loans, this debt consolidation can also save you interest charges. This is especially true when you land a balance transfer credit card with 0% or low Annual Percentage Rate (APR).
- A personal line of credit: This debt consolidation method has the same benefits as a personal loan. It involves taking an unsecured loan from a credit union or other financial institutions.
- Home equity line of credit: If you have a home and have repaid enough of the mortgage loan to have significant equity in the house, the home equity line of credit could be the go-to debt consolidation method if you want the interest charges reduced.
If your credit allows for either of the above credit lines, you may consider debt consolidation. However, it’s vital to note that this option isn’t always the best choice, and you may wish to speak with a credit counseling agency to determine what makes the most sense for you.
Consider debt consolidation if:
- You have a large amount of debt and larger timelines remaining
- Your credit score qualifies you for lower interest rate loans
- You have additional plans to enhance your finances, like a plan to avoid overspending
- Your cash flow can comfortably cover monthly debt repayment
So, what exactly do you gain by consolidating your debt? Let’s see the main pros and cons of debt consolidation below;
Benefits of debt consolidation vs bankruptcy
As an alternative to bankruptcy, consolidating your debt has several benefits, including streamlined finances, lower interest rates, and reduced monthly payments, as discussed below:
- Streamlined finances: Combining several debts into one loan reduces the number of monthly payments and interests, making it easier to manage your debt. In turn, this improves your credit and reduces the chance of late payment through a streamlined debt management plan.
- Reduced monthly payments: Suppose your good credit score allows you to take the lower-interest-rate personal loans; consolidating your debts may mean that you pay lesser monthly payments.
- May expedite payoff: Although debt consolidation leads to increased loan terms, you have the chance to pay your debt earlier, especially given that you make fewer monthly repayments.
- Can enhance your credit score: Combining several debts into one manageable loan allows you to make timely repayments, improving your credit score.
What are the drawbacks of a debt consolidation loan
Every yin has a yang, so let’s look at some of the risks and disadvantages of debt consolidation:
- May have added costs
- Could raise your interest rates – mainly if your credit score is poor
- It doesn’t necessarily solve the underlying financial challenges
You may sometimes analyze your income and debts and conclude that you cannot pay what you owe, even at reduced monthly payments or lower interest rates. This is where filing for bankruptcy comes in.
But, is consolidating debt like bankruptcy? What happens when I opt for bankruptcy? To answer all questions, let’s take a deeper dive into bankruptcy.
What is Bankruptcy?
In extreme cases, some consumers cannot afford to pay off their debts from their income and savings. In such cases, the individuals may consider filing for bankruptcy. Often overseen by a federal court along with the help of a bankruptcy attorney, this debt relief method protects businesses and individuals overwhelmed with debt.
Two types of bankruptcy that can apply to an individual are Chapter 7 bankruptcy and Chapter 13 bankruptcy. Either of these bankruptcies can effectively discharge or erase many types of debts, including unpaid rent, utility bills, credit card balances, and private debts.
However, bankruptcy cannot erase all debts. For instance, you cannot file for bankruptcy to have your criminal fines, evaded taxes, and court-ordered child support and alimony payments. Also, bankruptcy does not prevent auto financing and mortgage creditors from repossessing property named as collateral.
Let’s discuss the two types of bankruptcy:
Chapter 7 bankruptcy
Here, you surrender your assets to a court-appointed Licenced Insolvency Trustee who supervises the liquidation of your assets – with certain exceptions. Such assets as your primary vehicle, basic household furnishings, retirement account, and work-related equipment and tools are spared.
Once your assets are liquidated, the trustee notifies your creditors, and your outstanding debt is discharged. While this is one of the cheapest ways to file for bankruptcy, you should be ready to suffer the consequences of this debt relief method, including:
- Bankruptcy status will reflect on your credit report for ten years
- You’ll possibly lose the non-exempt property
- You can’t file for bankruptcy for seven years after the initial filing should you get into debt again
Chapter 13 bankruptcy
Here, you are allowed to keep your property provided you agree to a debt-repayment plan. Your attorney and the bankruptcy court negotiate a repayment plan for you for three to 5 years, during which you’re supposed to repay some or all of what you owe.
If you’ll have made the agreed-upon payments by the end of the three to 5 years, your outstanding debt is discharged, even if you’ll have repaid a certain percentage of the total amount owed.
You can speak with an attorney to see if you can qualify for this very-favorable bankruptcy option. Unlike the Chapter 7 bankruptcy, you get to retain your assets, and the debt disappears from your credit report after seven years. Also, under Chapter 13, you can file for bankruptcy again after two years after filing your first case.
Benefits of bankruptcy vs debt consolidation
Research shows that 522,808 individuals filed for bankruptcy in the U.S. in 2020 alone– and for a good reason! In addition to discharging your debts, bankruptcy protects you from debt lawsuits and tax consequences.
Here are a few benefits of filing for bankruptcy.
- No late fees
- No tax consequences
- An automatic stay against creditors
- Be done with debt lawsuits from lenders
- Eliminate wage garnishment from a lender
- No property repossessions
Cons of bankruptcy
Although bankruptcy protects you from the creditor, it has its drawbacks, including:
- Not everyone can qualify for the Chapter 7 bankruptcy – you must pass the Chapter 7 means test first
- Some debts are excluded in bankruptcy
- The creditor can still seize your house under Chapter 13
- It severely damages your credit score
Let’s look at the effect of debt consolidation vs bankruptcy on your credit score.
Effect of Bankruptcy and Debt Consolidation on Credit
Bankruptcy harm your credit score a big deal. Chapter 7 bankruptcy especially remains on your credit report for ten years, making it the worst negative event that can happen on your credit report.
And although the effect of the credit score disappears over time, many creditors won’t consider your credit application if you have a bankruptcy in your credit reports.
On the other hand, debt consolidation can have a negative or positive effect on your credit report. Combining your high balances loans into a personal loan could improve your credit score because of the reduced credit utilization ratio.
On the flip side, using a balance transfer credit card to combine several loans and credit cards could affect your credit score due to the high utilization situation. Specifically, if the total amount transferred to the credit card exceeds 30% of its borrowing limit, then you’ll be hurting your credit score. What’s more, the high utilization of HELOC accounts is likely to harm your credit score.
Generally, anything that leads to a high utilization ratio negatively affects your credit score. And given that the credit utilization ratio accounts for about 30% of your FICO Score, it’s always a good idea to maintain the ratio low.
Which is Better: Bankruptcy or Debt Consolidation?
Generally, debt consolidation is a better option than bankruptcy. This is especially true if debt consolidation provides you with a clear path to financial stability. If you are in debt due to medical bills, utility bills, poor spending habits, etc., consolidating your debts will benefit your credit score.
However, if you can’t change the spending habits that landed you in debt, consolidating your debt may land you in much worse situations. In such a case, bankruptcy may be good for you.
But given the strong negative effects of bankruptcy, it should be your last resort – after measures like debt management or debt consolidation aren’t viable or possible. Similarly, you may also wish to compare debt settlement vs bankruptcy, or debt consolidation vs debt settlement to help better determine which debt relief option is best for your situation.
The Bottom Line on Debt Consolidation and Bankruptcy
For most individuals, living debt-free is a dream come true. If you’re already among the millions of Americans caught up in some debt, you have several debt relief options at your disposal. Choosing the best option brings us down to the debate of debt consolidation vs bankruptcy. At the end of the day, debt consolidation may be a better option if you can afford the payments. And on the other Bankruptcy can help you get out of debt faster, but it will remain on your credit report for seven to ten years.
FAQ’s about Debt Consolidation vs Bankruptcy
1. Is debt relief through consolidation better than bankruptcy?
Yes. Bankruptcy is often recommended as the last resort when you’re trying to sort out your debts. This is so because bankruptcy adversely affects your credit score.
2. Is consolidating debt like bankruptcy?
No. Although these two are debt relief solutions, they are different. Debt consolidation entails merging your debts into a single monthly payment, whereas bankruptcy is a legal process that discharges your debt obligations.
3. Is Debt Settlement worse than bankruptcy?
No. Although bankruptcy frees you from creditors and debt collection, its effects on your credit score can linger for years. On the other hand, if negotiated properly, debt settlement can do far less harm to your credit score.
4. What are the drawbacks of a debt consolidation loan?
Although debt consolidation may help reduce your monthly payments and streamline your finances, it also has drawbacks. For instance, debt consolidation may not reduce your interest rates if your credit score is poor, it doesn’t necessarily solve your financial problems, and there might be up-front costs.