Debt Consolidation vs. Bankruptcy for Debt Problems: Which Is Better?

Sometimes, credit card payments seem to pop up every few days from unexpected medical bills, a job loss, or simply life’s twists and turns. Suddenly, you’ve got a debt amount you never planned on. But you’ve got options and with a little time, you can find a way out. 

One strategy many people find helpful is debt consolidation, which can simplify life by rolling multiple payments into just one. Another option is bankruptcy, which, in some cases, could give you a financial reset by clearing away some or all of what you owe.

Debt consolidation and bankruptcy may be worth considering if life has thrown you a curveball that's resulted in large bills. Let's walk through the benefits and drawbacks of debt consolidation and bankruptcy so you can understand both options and decide which, if either, is right for you.

Debt Consolidation vs. Bankruptcy: Key Differences At a Glance

Both debt consolidation and bankruptcy are reasonable solutions for dealing with overwhelming debt. It may help you to have a side-by-side comparison so you can get a better sense of which may be right for you. 

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How Debt Consolidation Works

Debt consolidation combines multiple debts into one. To consolidate your debts, you take out a new loan and use the money to pay off your existing accounts. The new loan should provide better terms, like a lower interest rate or more time to pay off your debt.

For example, if you have three credit cards with 26%, 24%, and 22% interest rates, you might consolidate them with a home equity loan at a 12% interest rate. If you qualify for a personal loan that has a 18% interest rate, that could save you money, too. 

This type of debt relief could make your life easier because you could reduce the number of payments and due dates to juggle and remember. Also, in many cases, debt consolidation could help you reduce the total amount of interest you pay on your debt by swapping higher interest rates for a lower one.

You can use different options to consolidate debt.

Balance transfer

A balance transfer credit card lets you move your existing credit card balances onto a single card that usually comes with a 0% introductory interest rate. This gives you relief from accrued interest for a period of time, but if you don't pay off your entire balance by the time your introductory period comes to an end, the interest rate on your remaining debt could skyrocket. 

You'll need to meet a credit card issuer's credit score requirements to qualify for a balance transfer.

Personal loan

A personal loan has you take out an unsecured loan to pay off your debt. You'll need to meet a lender's credit score, debt-to-income ratio, and income requirements to qualify. 

You use your loan proceeds to pay off your various debts immediately and then make a single fixed monthly loan payment until that debt is paid off. Falling behind on a personal loan could cause credit score damage.

Home equity loan

With a home equity loan, you borrow against your home equity to pay off your debt. You'll need to meet a lender's credit score, debt-to-income ratio, and income requirements, and you’ll need enough equity in your home to qualify. 

Your home is used as collateral for your loan, and you repay it in fixed monthly payments. Falling behind on a home equity loan could put you at risk of losing your home to foreclosure.

HELOC

A HELOC, or home equity line of credit, is similar to a credit card in that it's a revolving line of credit. You'll need to meet a lender's credit score, debt-to-income ratio, and income requirements, and have enough equity in your home to qualify for a HELOC. 

Your home is used as collateral. During your HELOC's draw period, you can borrow the funds to pay off your existing debt. You then repay your HELOC over time. Your payments aren't set in stone, since HELOC interest rates are typically variable, not fixed. Falling behind on a HELOC could put you at risk of losing your home to foreclosure.

Good candidates for debt consolidation

If you can still afford to make payments on your debt but want fewer monthly bills, debt consolidation might be a workable strategy for you. Debt consolidation makes the most sense if the new loan you get has better terms than the debts you want to pay off. Many people can qualify for a debt consolidation loan that has a lower rate.

Borrowing rates depend on market conditions and your credit history. If you have a good credit score, you’re more likely to qualify for a debt consolidation loan with a lower interest rate than someone with poor credit.

Another benefit of debt consolidation is the fixed repayment schedule if you use an installment loan to consolidate. If you have a target date for becoming debt-free, this setup could work nicely for you, since you’ll have an end date for your total payoff.

Debt consolidation isn't for everyone. It may not be suitable if you:

• Have so much debt you don't think you'll ever be able to pay it off

• Have very poor credit and are unable to qualify for any of the options listed above

• Are unemployed and don't picture yourself working soon

Is Debt Consolidation a Good Idea?

Whether consolidating debt is right for you depends on your individual needs and circumstances. If you have a consistent income and the ability to repay your debts, then it could be a good option. 

Some of the pros of debt consolidation are:

• Save money with lower-interest debt 

• Lower monthly payments 

• Simplify bill-paying with one payment instead of several

If the terms you qualify for aren’t much better than the terms on your current debts, consolidating may not help you as much. 

Debt consolidation and your credit 

Debt consolidation could affect your credit standing. First, when you apply for a new loan, your credit score could drop by a few points. That’s normal.

Then, when you pay off your credit card debt with money from an installment loan, you could notice credit score improvement because having high credit card balances can hurt your score. The trick is to avoid adding new debt to the credit cards once you pay them off.

Finally, pay your bills on time every month. Payment history has a big impact on your credit standing. 

Paying your bills on time and keeping your credit card debt low could put you in the best position to build and maintain great credit.

Freedom Debt Relief is not a Credit Repair Organization and does not provide, or offer, services or advice to repair, modify, or improve your credit.

How Bankruptcy Works

If your debts have become unmanageable and you don’t picture a path toward paying them in full, then bankruptcy is an option worth considering. With bankruptcy, you may be able to reorganize your debts or even completely walk away from some of them. The two most common types of bankruptcy for individuals are Chapter 7 and Chapter 13.

Chapter 7

A Chapter 7 bankruptcy, also known as a liquidation bankruptcy, may wipe away some or all of your eligible debts in a fairly short period of time. If you can afford a monthly payment, you probably won’t qualify for Chapter 7. 

Also, you may have to give up certain things that you own. The court will sell some of your possessions and give the money to your creditors. You don’t have to give up everything. You can typically keep certain household goods, clothing, some home equity, and other items known as bankruptcy exemptions. The list varies depending on where you live.

Some debts that may be dischargeable under Chapter 7 include:

• Credit card debt

• Medical debt

• Personal loan debt

• Unpaid utility bills

• Payday loans

• Lawsuit judgments

Generally, you can't discharge the following debts:

• Secured debts, like a mortgage

• Student loan debt

• Tax debt

• Child support and alimony debt

Chapter 7 typically takes three to five months from start to finish. Nearly all Chapter 7 cases filed result in a discharge of debts.

Chapter 13

A Chapter 13 bankruptcy reorganizes your debts. If you make too much money to file for Chapter 7, you could file Chapter 13 and pay back the debt over five years (three if you make less). You don’t have to give up the things you own. 

Only about half of Chapter 13 cases succeed, because the payment is typically very high and it’s hard for many people to stick with it for several years. 

The goal of Chapter 13 is not to discharge your debts. It’s simply to come up with a solution that allows you to pay them off over time, ideally in a more affordable manner. You could get some debt wiped away if you still have balances on eligible unsecured debts when you finish your plan.

Bankruptcy counseling

If you decide that filing for bankruptcy makes sense for you, you’ll be required to attend credit counseling before moving forward and another counseling course after you file. The cost of these courses varies but is typically about $10 to $50 per course. Your counselor should review your specific financial circumstances, explain your bankruptcy choices to you, and help you develop a budget plan. If you can't afford this counseling, you may be eligible to get it for free or at a reduced rate.

Good candidates for bankruptcy

A bankruptcy filing of any kind stops collection efforts, including foreclosure. Creditors must participate. They can’t opt out. If you’re being sued or pursued, bankruptcy could help you get your bearings.

Chapter 7 could be worth considering if you mainly have unsecured debts like credit cards, you don’t own much or anything that the court could take, and your income is low enough to qualify.

Chapter 13 could be a good option if, say, your home is in foreclosure and you want to save it, and can afford to. If your financial struggles were short-term and you have a good income, but you want the court’s protection while you get caught up, Chapter 13 might be a good fit.

Is Bankruptcy a Good Idea?

Filing for bankruptcy could help you discharge your debts and move forward without a dragged-out process, especially if you qualify for Chapter 7. Some of the pros of bankruptcy are:

• You could walk away from your eligible debts in a Chapter 7 bankruptcy in just a few months

• Forgiven amounts are usually not taxable

• Creditors must stop trying to collect on your debts after you file

Bankruptcy is a public record, so you might want to consider other options if you don’t want anyone to know about your financial situation.

If you don’t qualify for Chapter 7, another option to consider is settling your debts. Debt settlement is the process of working out an agreement with your creditor to clear your debt for less than the full amount you owe. The creditor forgives the rest. 

Anyone can negotiate with their creditors. If you don’t want to, you also have the option of working with a professional debt settlement company.

Unlike bankruptcy, debt settlement is private. Also, while most people spend five years in a Chapter 13 program, it’s possible to complete a debt settlement program in two to four years. 

Bankruptcy and Your Credit

Bankruptcy is a negative item on a credit report. How far your credit score falls depends on where you started out when you filed for bankruptcy. If you had a high credit score, you could lose hundreds of points. If you were already falling behind on your debts, you might experience less score damage. 

Chapter 7 stays on your credit for 10 years. Chapter 13 stays on your credit for seven years, the same amount of time as a collection account or late payment.

Credit Impact Comparison: How Each Option Could Affect Your Score

If you're looking to tackle your debt, one big question you may have is how a particular solution will impact your credit score. It's natural to be concerned about a drop in your credit score, and it's good to understand the consequences.

Debt consolidation may only have a minimal impact on your credit score. Every time you apply for a new loan, a lender does a hard inquiry on your credit report, resulting in a drop of a few points. Your score may also decrease a bit if the average age of your credit accounts shrinks due to consolidating with a brand-new loan.

If you make your debt consolidation loan payments on time, your credit score could improve significantly. If you fall behind on a debt consolidation loan, then, you risk credit score damage.

Bankruptcy is likely to result in a substantial drop in your credit score. A Chapter 7 filing will typically stay on your credit report for up to 10 years, while a Chapter 13 will stick around for up to seven years. During this time, it may be difficult to borrow money if you need to.

Debt consolidation and bankruptcy are suitable for different financial situations. Debt consolidation could be a good strategy for people who can pay off their debt. Bankruptcy is an option worth pursuing if you're experiencing financial hardship and feel your debt isn't payable.

Bankruptcy gives you legal protection from creditors. Your credit score might take a hit, but it could get you to a more stable place financially, when you can work on rebuilding your credit. 

Cost Considerations: Understanding Financial Implications

You're apt to encounter certain costs when you consolidate debt. These include:

• Loan origination fees

• Closing costs

• The interest rate you get on your new loan

With bankruptcy, there are these costs to consider:

• Court filing fees

• Attorney fees

• Credit counseling fees

There's no one-cost-fits-all solution for bankruptcy or debt consolidation. With debt consolidation, for example, the amount you pay to set up your loan and close on it will typically hinge on the amount you're borrowing.

With bankruptcy, the typical cost of court fees and credit counseling is $350 to $500, but your costs will depend on your specific situation. You can expect to pay $1,250 to $2,200 for a Chapter 7 bankruptcy, or around $3,125 to $6,250 for a Chapter 13 bankruptcy. Again, the exact number depends on the specifics of your situation.

While it's important to consider the costs of addressing your debt, also think about the long-term financial implications of each approach. Bankruptcy could be the quickest way to get back on your feet if you qualify for Chapter 7, but you'll need to weigh the expense and credit score impact against that benefit.

Another option you can consider is debt relief, where your total debt balance is negotiated down by a professional debt relief company. This typically costs 15% to 25% of the debt being settled.