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

Bankruptcy vs. Debt Consolidation

What Is Bankruptcy?

Bankruptcy is a legal proceeding that can protect people and businesses saddled with crippling debt.

The bankruptcy process can eliminate many types of debt, including unpaid credit card accounts, rent, utility bills and private debts owed to friends or family members. However, bankruptcy cannot discharge all debts. Unshielded exceptions include alimony and child support obligations, unpaid taxes and criminal fines.

Bankruptcy can also grant an automatic stay on certain creditors, putting a stop to debt collection efforts. If you have a secured loan—a debt that uses property as collateral, such as a mortgage or auto loan—bankruptcy may also delay repossession or foreclosure and may give you some time to catch up on payments. However, it depends on the type of bankruptcy you pursue and how you manage the process.

Learn more: Bankruptcy: How It Works, Types and Consequences

Chapter 7 Bankruptcy

Under Chapter 7 bankruptcy, a court-appointed trustee oversees the sale of eligible assets you hold and then distributes the proceeds among your creditors. That said, certain assets are exempt from this liquidation process. If the sale of your property cannot satisfy your debts, creditors must accept partial payment—or none at all—and the court discharges any remaining obligations.

Chapter 7 bankruptcy is designed for people who are unable to even partially repay some of what they owe. As a result, you'll need to pass a means test to be eligible to file. While it can delay foreclosure or repossession, it may not be sufficient to prevent them entirely unless you can catch up on your missed payments.

Chapter 13 Bankruptcy

A Chapter 13 bankruptcy proceeding establishes a debt repayment plan, which lasts three to five years, during which you'll repay some or all of the amount you owe. If there are any balances remaining after you complete the payment schedule, they'll be discharged.

Chapter 13 bankruptcy doesn't require a means test, and it allows you to retain more of your assets compared to Chapter 7. Additionally, it may give you a better chance of avoiding foreclosure or repossession on a secured loan because it allows you to get caught up on payments over a longer period of time.

That said, the success rate for completing a Chapter 13 bankruptcy can range from 40% to 70%, depending on where you live and which law firm you choose. If you fail to stick to your plan, your creditors can take up collection efforts again.

Learn more: What Happens When You File for Bankruptcy?

What Is Debt Consolidation?

Debt consolidation is the process of combining multiple high-interest loans or credit card accounts into a single debt with a more affordable interest rate. However, you may also choose to consolidate a single high-interest balance.

The process involves applying for a new loan or credit card, which you'll use to pay off the debts in question. In addition to interest savings, debt consolidation may also lower your monthly payment, and it could help you pay down your debt more quickly.

That said, you'll typically need a good credit score or better to make it worth your while. Otherwise, you may not qualify for an interest rate that's low enough to create savings.

How to Consolidate Debt

There are several different ways you can consolidate debt. Understanding how each option works can help you determine if it's the right fit for you.

Balance Transfer Credit Card

A balance transfer credit card offers a low or 0% introductory annual percentage rate (APR), which can help you minimize interest charges or avoid them altogether. Depending on which card you choose, you may have anywhere between 12 and 21 months to pay down your debt, or at least a significant chunk of it. Depending on how much you pay off, you could save hundreds of dollars in interest.

That said, any balance that's left over will be subject to the card's regular APR, which can be upwards of 20%. Additionally, you'll typically need to pay an upfront balance transfer fee, which can range from 3% to 5% of the transferred amount. There's also no guarantee that you'll qualify for a credit limit that's high enough to cover all your debts.

Debt Consolidation Loan

A debt consolidation loan is a personal loan used to pay off high-interest debts, such as credit card balances. On average, personal loans have a lower interest rate than credit cards. They can also provide a structured repayment plan—usually one to seven years—which can help if you've gotten complacent with your credit card payments.

However, if you don't have good credit, you may have a hard time qualifying for an interest rate that's low enough to make a consolidation loan worthwhile. Additionally, many lenders charge an upfront origination fee, which can be as high as 12% of the loan amount. This fee is deducted from your disbursement, potentially requiring you to borrow more to cover your balances.

Home Equity Loan

If you're a homeowner with significant equity, a home equity loan allows you to tap some of that equity. This option provides a lump-sum disbursement at a relatively low fixed interest rate, secured by your home. Depending on the lender and loan amount, repayment terms can range from five to 30 years. If you sell your home before you complete repayment, you'll use your proceeds to pay off the remaining balance.

To qualify for a home equity loan, you'll typically need a credit score of 620 or higher—though many lenders require at least 680—and a loan-to-value ratio below 80%. Also, keep in mind that closing costs can range from 2% to 5% of the loan amount. If you fail to keep up with payments, you could risk losing your home.

Home Equity Line of Credit

A home equity line of credit (HELOC) is another way you can tap your home's equity to consolidate high-interest debt. You'll typically get a draw period of up to 10 years, during which you can borrow up to your credit limit and repay it as needed. However, you may also opt to make interest-only payments during this time. At the end of the draw period, you'll enter a repayment period of up to 20 years, during which you'll pay down your remaining balance.

It's important to note that HELOCs typically have variable interest rates, which can fluctuate over time—though some lenders allow you to convert some or all of your balance to a fixed-rate loan. In addition to closing costs—which can range from 2% to 5% of the loan amount—you may also be subject to an annual fee, inactivity fees and a prepayment penalty. Approval requirements are similar to those of home equity loans.

Learn more: Is It a Good Idea to Consolidate Debt?

How Do Bankruptcy and Debt Consolidation Affect Credit?

Both bankruptcy and debt consolidation can affect your credit score. However, the extent of that impact can vary depending on how you choose to tackle your debt.

Bankruptcy

If you're thinking about filing for bankruptcy, your credit score may already be in rough shape due to missed payments, collection accounts and other negative marks. That said, bankruptcy can keep your score down because it indicates that you're not capable of paying your debts as originally agreed.

What's more, a Chapter 7 bankruptcy will remain on your credit reports for 10 years from the filing date, while Chapter 13 stays on your reports for seven years. During that time, the public record could make it more challenging to rebuild your credit—though not impossible.

Debt Consolidation

There are a few different ways debt consolidation can impact your credit, both for better or worse. Here's a quick summary:

• Applying for credit: When you apply for a loan or credit card, the lender will typically run a hard inquiry on one or more credit reports. A single inquiry won't have much of an impact on your credit score, but multiple inquiries in a short period may have a compounding effect. That said, hard inquiries only affect your FICO^® Score^☉ for 12 months.
• Opening a new account: Opening a new loan or credit card can negatively impact your length of credit history because it decreases the average age of your accounts. Over time, however, your credit score will recover, especially if you minimize new credit accounts.
• Credit utilization: Your credit utilization rate is the percentage of available credit you're using on a single credit card, as well as across all of your credit cards. If you consolidate credit card debt with a loan, it could reduce your utilization rate to 0%, which could help your credit. However, if you use a balance transfer card, and the transfer results in a higher single-card utilization rate, it could hurt your credit until you pay down the balance.
• Payment history: Consolidating debt can help make monthly payments more affordable. If you can maintain a positive payment history, it can help improve your credit over time.

Is Bankruptcy or Debt Consolidation a Better Option?

On paper, debt consolidation is streets ahead of bankruptcy, especially in terms of credit impact. However, the right decision for you will depend on your situation. Here are some potential scenarios in which one may be better than the other.

Consider bankruptcy if:

• You're behind on your debt payments, and you can't afford to pay them.
• Your credit score is considered fair or poor (generally a FICO^® Score below 670).
• You've pursued other debt relief options and failed to achieve your goal.
• You're experiencing financial hardship.
• You're facing foreclosure or repossession.

Consider debt consolidation if:

• You have a significant amount of high-interest debt.
• You have a good or excellent credit score.
• Your top priority is to save on interest charges or pay down your debt more quickly.
• You're looking to simplify your monthly payments.
• You have a steady income and can afford the new payments.

As you consider your options, it may help to consult with a credit counselor, who can look at your budget and debt and help you craft a plan of attack.

Alternative Ways to Get Out of Debt

Before you choose bankruptcy or debt consolidation, it's important to evaluate all of your options. Depending on your situation, here are some alternatives to consider:

• Debt snowball method: With the debt snowball method, you'll make minimum payments on all debts and add any extra money you can afford to the smallest balance. Once it's paid off, you'll roll that payment into the next smallest debt, repeating the process until you've eliminated all of your debts.
• Debt avalanche method: The debt avalanche method follows the same process as the snowball method. However, instead of targeting your smallest balances first, you'll focus on the debts with the highest interest rates.
• Debt management plan: A debt management plan (DMP) is a repayment plan you can set up through a credit counseling agency. With a DMP, the agency may be able to negotiate a lower interest rate, reduced monthly payment and other forms of relief. Each month, you'll make a single payment to the agency, which will distribute the funds to your creditors.
• Debt settlement: If you've fallen behind on payments, debt settlement may be worth considering over bankruptcy. With this option, you may be able to negotiate to pay less than what you owe to satisfy the debt. Like bankruptcy, however, debt settlement can significantly damage your credit.

The Bottom Line

If your debts are piling up and you're starting to feel overwhelmed, a debt consolidation strategy can help ease the pressure and save you money over the long haul. If your circumstances make it impossible to get new credit, using the bankruptcy process to get a clean slate on debt is a painful choice, but one you can eventually recover from and move forward.

Whether you're contemplating a debt consolidation loan or working to rebuild your credit to stave off bankruptcy (or recover from it), keeping track of your credit report and FICO^® Score from Experian can help you know where you stand.