Debt Consolidation vs. Bankruptcy: Which Is Better?

Many people carry more debt than they can comfortably manage, and real solutions exist to help you move forward. Debt consolidation and bankruptcy are two of the most common paths people use to get their finances back on track. 

Debt consolidation combines your bills into one new loan with new repayment terms, while bankruptcy uses the court system to reorganize your debt or discharge some or all of what you owe. 

Debt Consolidation vs. Bankruptcy: Key Differences at a Glance

Debt consolidation combines multiple debts into one new loan with new repayment terms. Bankruptcy uses the federal court system to reorganize your debt or discharge some or all of what you owe. Both could be reasonable options for overwhelming debt, and a side-by-side comparison could help you determine which one may fit your situation. 

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Understanding Bankruptcy and Debt

How Debt Consolidation Works

Debt consolidation combines multiple debts into one loan. 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. Debt consolidation could also help you reduce the total interest you pay by swapping higher interest rates for a lower one.

There are different options to consolidate debt.

Balance transfer

A balance transfer credit card is a way to 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. 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

With a personal loan, 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.

If you fall behind on payments, your credit score could suffer 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.

If you fall behind on a home equity loan, you risk losing your home to foreclosure.

HELOC

A HELOC, or home equity line of credit, is a line of credit that works somewhat like a credit card. 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 borrow the funds to pay off your existing debt. You then repay your HELOC over time. Your payments usually aren't set in stone, since HELOC interest rates are typically variable, not fixed.

If you fall behind on a HELOC, you risk losing your home to foreclosure.

Good candidates for debt consolidation

If you can still afford to make payments on your debt and 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.

Loan 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 want to become debt-free by a set date, this setup could work nicely for you, since you'll have an end date for your total payoff.

Debt consolidation may not be suitable if you:

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

• Have a lower credit score and are unable to qualify for any of the options listed above

• Are unemployed and don't expect to be working soon

Is Debt Consolidation a Good Idea?

Debt consolidation is generally a good option if you have steady income and the ability to repay your debts.

Debt consolidation could help you:

• Save money with lower-interest debt

• Lower your 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 might hurt your score.

Don't add new debt to the cards once you pay them off.

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

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 discharge some or all of your eligible debts in a fairly short period of time. If you can afford a monthly payment, you're unlikely to qualify for Chapter 7.

Also, you may have to give up certain things that you own. The court may sell some of your possessions and give the money to your creditors. You generally don't have to give up everything. You may 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

• Certain 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 money). You don't have to give up the things you own.

Not all Chapter 13 cases succeed because the payment is typically very high and can be hard for some people to stick with it for several years.

Chapter 13 aims to create an affordable plan for paying off your debts over time, rather than to discharge them outright.

You could have some remaining eligible unsecured debt discharged when you finish your plan.

Bankruptcy counseling

If you decide bankruptcy fits your situation, you'll need to complete a credit counseling course before you file and another course after you file.

The cost of these courses varies. Typically, each course costs $10 to $50.

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 most foreclosure proceedings. Creditors 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, you have a good income, and you want the court's protection while you get caught up, Chapter 13 might be a good fit.

Is Bankruptcy a Good Idea?

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.

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

Debt consolidation and bankruptcy affect your credit score in different ways.

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 because you added a 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, you risk credit score damage.

Bankruptcy is likely to result in a substantial drop in your credit score. A Chapter 7 filing typically stays on your credit report for up to 10 years, while a Chapter 13 typically sticks 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 afford to 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 is likely to take a hit. It could also get you to a more stable financial place where you are better able to 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 typically hinges on the amount you're borrowing.

With bankruptcy, the typical cost of court fees and credit counseling is $340 to $550. Your costs depend on your specific situation.

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.

Also weigh the long-term financial implications of each approach against the immediate costs.

Bankruptcy could be one of the faster ways to get back on your feet if you qualify for Chapter 7. Weigh the expense and credit score impact against that benefit.

Another option you might 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.

Debt settlement may negatively impact your credit.

How to Decide Between Debt Consolidation and Bankruptcy

Consider debt consolidation if you have steady income, could afford a new monthly payment, and want to pay down your debt over time without a court process. Consider bankruptcy if your debt has grown larger than your income is able to support, or if you're facing a lawsuit, wage garnishment, or foreclosure and need immediate legal protection. Your credit score, your total debt amount, and how quickly you need relief all play a role in this decision. A nonprofit credit counselor or a bankruptcy attorney could help you review your specific situation before you choose a path forward.