Debt Consolidation vs. Bankruptcy: Which is Better?

If you’re like most Americans, you have several credit cards, perhaps a mortgage, student loans, and a car or truck payment. All of that debt can add up quickly, and eventually, it can feel overwhelming.

You might feel like you’re drowning in debt with no way to get clear of it. If this sounds like you, you’re not alone. In fact, the average credit card balance among cardholders in America was $6,354 in 2017, according to a 2018 Experian State of Credit survey.

If you’re in over your head with your credit card debt and debt from other sources, you may be considering bankruptcy. Debt consolidation might also be an option on the table for you. Which one is the best answer for you, and what happens when you choose one? Let’s take a look.

On this page:

• What is Debt Consolidation?
• What is Bankruptcy?
• Qualifying
• How Long Does It Take and What Are the Costs?
• Tax Considerations
• Benefits and Risks

What Is Debt Consolidation?

Debt consolidation loans are offered by banks, credit unions, and specific consolidation lenders. It is the combining of all of your debt into one loan. The new loan, which is essentially a personal loan pays off each of your debts, and then you make one monthly payment to pay off that new loan. Here’s how debt consolidation works.

If you have a total of $30,000 in debt, including an auto loan for $20,000 and a credit card for $10,000, your total payment to those two debts may be about $1100 per month. If you take out a consolidation loan, you could drop your monthly payment to under $650, with a lower interest rate as well, saving you hundreds of dollars per month.

>> Read More: Does Debt Consolidation Hurt Your Credit?

A debt consolidation loan is a bit different than a 0% balance transfer to a new credit card. While some people like to move their debt to a new card offering a 0% APR for 12-18 months, this often doesn’t end up working out well.

Most people don’t change their spending habits—and as soon as the original debt is moved to the 0% card, they start using that freshly paid off card again, essentially starting the cycle over again, this time filling that original card a second time with more debt.

Meanwhile, if you don’t pay off the transferred balance before the 0% APR rate is over, you could end up paying a very high rate of interest on that original debt—and now you have new debt on the card you just paid off as well. With a debt consolidation loan, the rate is often fixed for the life of the loan.

What Is Bankruptcy?

Bankruptcy is a legal status offered to people and businesses who can no longer pay their debts. It offers a way for someone to start over while still treating creditors fairly. There are two kinds of bankruptcy proceedings: Chapter 7 and Chapter 13, named after the part of the law governing them.

Chapter 7 Bankruptcy

A Chapter 7 bankruptcy is often called a liquidation. The person responsible for handling your case—called a trustee—sells your assets to raise money to pay off your creditors.

Extra cars, boats, valuable collections, and many other assets can be sold to help offset your debt. You can exempt, or keep, the basics that you still need to live and work, such as one car, household furnishings, your clothing, and in some cases your home.

The proceeds from all of the sales are applied to each of your creditors, who agree to accept that money as a final payment on your total bill.

Not all debts can be included in a bankruptcy, and it’s important to understand what is excluded. Student loan debt, child support back pay, and even income tax obligations to the IRS are considered “nondischargeable” debt that is not included in a bankruptcy.

Chapter 13 Bankruptcy

A Chapter 13 is considered a reorganization instead of a liquidation, and instead of wiping out your debt and giving up your assets, it allows you to avoid foreclosure and forfeiture by agreeing to a repayment plan that will pay off your debt in three to five years. You’ll be assigned a minimum payment per month that is based upon your income, debt amounts, and any property value.

Both types of bankruptcy show up on a credit report for the next seven years and can affect your ability to get credit for several years after your debts are discharged.

Qualifying

To qualify for a debt consolidation loan, you’ll need a few things. First, you’ll have to have good to excellent credit. The time to apply for a debt consolidation loan is long before you find yourself making late payments or missing them entirely.

Once you’re in real debt trouble, the chances are good that your credit will have already taken enough of a hit to negatively affect your ability to get approved; so, if you’re looking at a debt consolidation, you’ll want to do it before you get in over your head.

You’ll also need proof of income, and proof that you’re financially stable and can pay back the loan. If you’ve lived in your home for several years, for instance, that can go a long way toward showing you have the will and ability to make on-time payments.

Depending on the type of consolidation loan you want, you might also have to show equity in an asset. For example, a home equity product can help you get your debt consolidated, but in order to get approved, you’ll need to have equity in your home.

With a bankruptcy, it’s already assumed that you’re in deep financial trouble—that’s why you’re applying. As a result, your credit score isn’t as much of a factor. What is, however, is your income.

Due to recent restructuring of the bankruptcy laws, you’ll now have to take a “means test” to show that your income is low enough to file for Chapter 7 bankruptcy. This is meant to keep high-wage earners from filing for bankruptcy when they actually have the means to pay off their debts.

To pass the means test, you’ll need to show one of two things:

• Your income is less than the median income for a household of your size.
• You do not have enough disposable income to repay your debts.

For the purpose of this test, disposable income is defined as what you have left over after paying for food, shelter, clothing, and medical care; monthly expenses like your cable television, streaming services, or cell phone don’t count. In some areas, transportation is also considered a mandatory expense.

How Long Does It Take and What Are the Costs?

A debt consolidation loan may have origination fees, and if you go with a home equity product, you’ll likely have closing costs as well. You can usually get approved for a consolidation loan and have your funds disbursed within a few weeks.

With a bankruptcy, however, that time frame is much longer—and possibly more expensive. The average bankruptcy costs between $1,500 and $4,000 in court fees and attorney fees. The filing fee for a Chapter 7 is $335, and a Chapter 13 is $310. Your attorney/trustee will charge you additional fees on top of that, and the amount generally depends on how much debt you have and how complex your situation is. A bankruptcy can also take four to six months from start to finish.

Tax Considerations

With a debt consolidation loan, there are no real tax implications unless some of your debt is forgiven or settled. The amount that is forgiven is considered income, and you’ll need to pay taxes on it.

In a bankruptcy, you’re not legally responsible for the unpaid amount because it is not considered income if it’s dissolved as part of the bankruptcy. If your debt is partly made up of tax obligations, however, those aren’t included in a bankruptcy—you’ll need to pay those separately.

What Are the Risks?

Debt consolidation can help individuals and families get out from under debt. Depending on how you go about consolidating, however, you can actually put yourself at greater risk. If you consolidate your loans with a home equity product, your home is now at risk of foreclosure if you cannot, or do not, make your payments. If you do not change your spending habits significantly, you could also end up starting the unhealthy financial cycle all over again, only to find yourself in the same situation—now with an additional payment for your consolidation.

In addition, a debt consolidation loan might lower your monthly payment, but you aren’t guaranteed a lower interest rate—and it stretches out your repayment term. You’ll end up paying more over time than you would have if you kept making your original payments. You’ll also be in debt for longer.

With bankruptcy, your risks are a bit different. Once you have filed for bankruptcy and your debt is discharged, any creditor, employer, or other party for the next seven years will see it on your credit report.

A recent bankruptcy is a huge risk for lenders you’ve applied to for credit, and it can take several years before they will view you as an acceptable risk again. After a bankruptcy, you’ll want to be very careful to always make your payments on time, live within your means, and keep spending under control so you can start building a solid credit history.

What Are the Benefits?

A debt consolidation loan can help you get a handle on your unsecured debt. If you’re willing to change your spending habits and financial practices, you could even find yourself able to pay extra on the loan, essentially paying it off faster.

A bankruptcy can give you a clean start; while you’ll need to work hard to restore your credit after a bankruptcy, within a few years you could see your credit score climb to an excellent rating again.

Which Option Is Right for You?

The question of which option is the best depends on your personal financial situation. If you have good credit now but have come up against sudden medical bills or are in a temporary setback, a consolidation loan can give you some room to breathe while you get back on your feet.

If, however, you have multiple credit cards carrying high balances or are currently in more debt than your annual income, you may wish to consider bankruptcy to wipe it all out and start over. Finances affect far more than your wallet—they can also affect your home life, stress level, and much more. There comes a time when getting a fresh start might be your best option to keep your sanity in the long-term. 

Before you choose one of those options, however, you could also check out a few of the other things available, such as credit counseling/working with a credit counseling agency, debt management plans, and even debt settlement companies.

Some creditors will accept as little as 50% of the total debt if you can pay it in one lump sum. Working with a qualified debt consolidation company or a nonprofit organization can be helpful also. Whatever you choose, make sure it’s the right decision for you and your family.