Debt Consolidation vs. Bankruptcy

Procrastination is considered a bad habit for a good reason. Credit card debt is often the same kind of kick-the-can-down-the-road behavior with far more serious consequences than simply putting off a diet or workout program for another day.

The average American family with credit card debt carries a balance of $8,425. And in most cases, unpaid credit card balances often keep company with other debt: a student loan and/or a home loan, each requiring either a fixed or minimum monthly payment.

If that sounds a little too much like your situation, it’s time to get brutally honest with yourself and examine if you have enough income to fund a debt consolidation plan or whether your finances are so out of whack that your best alternative is to file bankruptcy.

Financial experts recommend first taking stock of your debt, an initiative that a certified financial planner or nonprofit credit counseling can facilitate.

“Nonprofit credit card counseling can offer valuable guidance and education,” said Avigdor Grunwald, CEO of Fair Capital. “These organizations provide personalized advice, help individuals understand their options, and even set up debt management plans. This can lead to lower interest rates and waived fees, making it easier for individuals to pay off their debt.”

Though there are an assortment of tools and strategies to reduce debt and make it more manageable, debt consolidation and bankruptcy are two of the most common and most effective.

Debt consolidation turns an assortment of unsecured credit card debts into a single, affordable monthly payment. The goal is to eliminate debt in 3-5 years. 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.

What Is Debt Consolidation?

A debt consolidation program is a strategy to reduce the interest rate and lower the monthly payment on credit card bills by combining them into a single payment. To understand what you can afford on a regular basis without missing payments it’s important to take stock of all your outstanding debt.

There are a number of ways to consolidate debt.

• Debt Management Program: Also known as a credit consolidation program, in a debt management program a nonprofit credit counseling agency works with card companies to reduce the interest rate on your debt to around 8%, then collects monthly payments from you (including a service fee) and pays off your creditors in a 3-5 year timeframe.
• Debt Consolidation Loans: Taking out a debt consolidation loan through a bank, credit union or online lender often provides a much lower interest rate (if your credit score warrants it) than you’re paying on your credit card balances. 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 offering a zero interest rate for a specified period, usually 12-18 months. If your credit score is above 680, a balance transfer credit card might be a great option. “Balance transfer cards can be beneficial if the debt can be paid off within the promotional period,” Grunwald said.
• Home Equity Loans/Home Equity Lines of Credit (HELOC): Borrowing against your home’s equity, you use a lump sum to pay off credit card or other high interest debt. With a HELOC for debt consolidation you only pay interest on the portion of the line of credit you use rather than the entire sum of a home equity loan.
• Secured Personal Loans: A personal loan from a bank or private lender at a lower interest rate than you’re paying on your current debts allows you to pay off some of those debts and leaves you with a smaller monthly check to write.
• Do-It-Yourself Debt Management: You can always contact your card companies and offer to repay them at a lower interest rate. But creditors don’t have to accept your terms in do-it-yourself debt management, so consider a nonprofit credit counselor to help you propose a repayment plan. 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 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 (often 3-5 years) for eliminating your debt.
• It maintains your access to credit.
• A loan modification or repayment plan could prevent efforts to foreclose on your home.
• 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 plan just transfers debt from one source (or sources) to another.
• 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.
• Paying off a consolidated debt could take several years. Other methods might offer a quicker resolution.
• It requires you to curb 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.

“A debt consolidation plan helps protect credit scores as it involves paying debts in full,” Raymond Quisumbing, an author and certified financial planner, said. “But it may not address the core financial issue that led to the debts in the first place.”

» More About: Pros and Cons of Debt Consolidation

What Is Bankruptcy?

After analyzing your debts and income – and/or speaking with a nonprofit credit counselor or certified financial planner – bankruptcy might be the best alternative if the conclusion is you’re incapable of paying what you owe, even at a lower interest rate or reduced monthly payments, over the next five years.

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

Both offer a second chance to get your finances in order. Whether you file a Chapter 7 or a Chapter 13 bankruptcy, the process 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

In a Chapter 7 bankruptcy, a court trustee sells 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 of value. The proceeds go to pay off your creditors.

Exempt items may include your home, clothes, household furnishings, work tools and car. In other words, 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.

• When 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 usually takes 6-8 months.
• You can keep most of what you need to live and work.
• It’s almost always successful. People who are represented by an attorney win their Chapter 7 cases 96% 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 higher than your state’s median income, you might not qualify.
• A Chapter 7 bankruptcy stays 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.
• It isn’t free. Filing costs $338 in court fees and attorney fees range from$1200 to $1800.
• 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. The repayment plan lasts from 3-5 years. Unsecured debts (such as credit cards) are discharged upon completion.

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 you can use 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. Attorney fees usually are higher than Chapter 7, ranging from $2,500 to $3,500.

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, eligibility depends on how much debt you are carrying.
• 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. Your score will drop anywhere between 100-200 points.

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 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 setback should only last for 6-8 months, and the temporary drop in your score shouldn’t be drastic. But in some cases it could take longer to see the positive effects.

“A hard credit check can decrease your credit score by a few points and (stay) on your credit report for two years,” Grunwald said. “However, its effect diminishes over time and is less damaging than bankruptcy.”

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, that reduces the amount of your available credit, which in turn can reduce your credit score.

Regardless of the debt consolidation plan you choose, your credit score will rise 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, is often 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 previously in the good range (700 or above). The impact on a low credit score isn’t as significant, but bankruptcy nonetheless will cause a steep 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. 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 in the near future. 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 to where you want it.

Alternatives to Debt Consolidation and Bankruptcy

Before deciding on debt consolidation or a bankruptcy filing, it’s worth investigating 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 nonprofit credit counselor examines your income and expenses and helps 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): 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.
• Debt Settlement: In debt settlement, you (or a company you hire) negotiates with a lender or collection agency to settle the debt for less than what is owed. Just know debt settlement appears on your credit report for seven years and can lower your credit score by 100-200 points.
• Budgeting: 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.

Debt Consolidation or Bankruptcy, Which Is Better?

The state of your finances, your assets and your credit score are all factors that help determine whether debt consolidation or bankruptcy is the better path.

For instance, if you realize you’re 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.

Conversely, 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 could be a good alternative.

“You are a better candidate for debt consolidation if you have a stable income,” Quisumbing said. “On the other hand, you might be a suitable candidate for bankruptcy if you have an overwhelming amount of debt that cannot be feasibly repaid through consolidation, limited ability to make payments, and/or are facing imminent legal consequences as a result of those debts.”

Who Is Debt Consolidation Best For?

If not quite like the saying about how no two snowflakes are alike, your financial situation is unique and can tell a lot about whether debt consolidation is your best option.

In general, Grunwald says, your income and size of the debt are two of the most important factors.

“Someone who is able to make consistent payments may be a better candidate for debt consolidation,” he said.

The factors to consider when deciding if debt consolidation is right for you:

• Your credit score: A higher score means a better chance of getting a debt consolidation loan that works for you.
• Your income: The idea is to pay off your debt under new loan terms while protecting your credit, so your ability to make consistent payments is crucial. Do you have a steady income? Or work on a paid-per-project basis?
• Job security: It’s not always easy to predict but a job that offers security and comes with consistent raises or yearly bonuses gives you a better chance to make consistent payments and/or pay down your debt earlier than expected.
• Size of the debt: Make an honest assessment about the size of your debt to decide whether you can realistically pay it off in 3-5 years.
• Your spending habits: If you’ve worked with a nonprofit credit counselor and are committed to sticking to a new budget and changing your spending habits debt consolidation could be the best available option.

Who Is Bankruptcy Best For?

Bankruptcy is a last resort for some but there are also factors that make Chapter 7 or Chapter 13 bankruptcy a better overall strategy than debt consolidation.

• Your debt is unmanageable: You find yourself borrowing money to pay your bills or you need to pick and choose which bills you can afford to pay in a particular month.
• You’ve experienced a job loss: If your income is below the median for a household your size in your state and you don’t have pricey assets you can’t afford to lose, Chapter 7 may be your best option. Chapter 13, also known as wage earner’s bankruptcy, is the option for people who don’t qualify for Chapter 7 and need to protect their assets.
• Your debt has gone to collection: If you need to stop threats of foreclosure and/or wage garnishment, bankruptcy filings provide you protection.
• The majority of your debt is dischargeable:  Some debt is eligible for discharge in bankruptcy like medical bills, credit card balances and personal loans. Some, such as tax debt, child support and alimony, are typically not eligible for discharge.
• Your credit score is already damaged: In this case, you don’t qualify for a consolidation loan. While bankruptcy can impact credit for up to 10 years, individuals with low credit have less to lose by filing and credit scores can actually improve with the removal of negative items from a credit report.

In summary, Quisumbing says, you might be a suitable candidate for bankruptcy if “you have an overwhelming amount of debt, limited ability to make payments, and are facing imminent legal consequences as a result of those debts.”

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 – actually before 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 speak with a certified credit counselor at a nonprofit agency such as InCharge Debt Solutions. 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 debt consolidation or a bankruptcy filing fits, or doesn’t fit, your particular financial circumstances.

“Nonprofit credit card counseling can help people understand the situation they are in,” Quisumbing said. “They can conduct a personalized financial assessment and they can help negotiate with creditors as to how their client can settle their debts in a more reasonable and realistic manner.”