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

If you’re struggling to keep up with your debt, you may be considering debt consolidation or bankruptcy. With debt consolidation, you consolidate multiple debts into a single payment. Filing for bankruptcy, on the other hand, could mean having some or all of your debts wiped out. We’ll walk you through the benefits and drawbacks to each option.

How Debt Consolidation Works

Debt consolidation is the process of combining 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 10% interest rate. If you qualify for a personal loan that has a 16% 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 can help you reduce the total amount of interest you’re paying on your debt by swapping higher interest rates for a lower one.

Good candidates for debt consolidation

If you can still afford to make payments on your debt but want fewer monthly bills, you may be a good candidate for debt consolidation. Debt consolidation makes the most sense if the new loan (or in some cases, credit card) you get has better terms than the debts you want to pay off. Since credit cards are notoriously expensive, 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 lower interest rate on a debt consolidation loan 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 milestone by which you want to be debt-free, this setup could work nicely for you, since you’ll have a target date for your total payoff.

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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 see credit score improvement. That’s 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 very big impact on your credit standing. 

Paying your bills on time and keeping your credit card debt low 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 see 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 your debts. 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 debts in a fairly short period of time. However, if you can afford a monthly payment, you probably won’t qualify for a Chapter 7 filing. 

Also, you may have to give up certain things that you own. The court will sell them and give the money to your creditors to the most reasonable extent possible. You don’t have to give up everything. You can keep household goods, clothing, some home equity, and other items. The things you can keep are called bankruptcy exemptions, and the list varies depending on where you live.

Chapter 13

A Chapter 13 bankruptcy is a reorganization of your debts. If you earn too much to qualify for Chapter 7, you could file Chapter 13 and get on a payment plan for five years (three if your income is low). You don’t have to give up the things you own. 

Only about half of Chapter 13 cases succeed. The payment is typically set to be very high, and it’s hard to stick with it for several years. 

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 typically ranges from $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 (and can afford to) save it. 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:

• If you qualify for Chapter 7, you can walk away from your eligible debts 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 5 years in a Chapter 13 program, it’s possible to complete a debt settlement program in 2-4 years. 

Bankruptcy and your credit

Bankruptcy is a serious negative item on a credit report. How far your credit score falls depends on where it was 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 7 years (the same amount of time as a collection account or late payment).