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

debt consolidation vs bankruptcy
BY Erik J. Martin
Apr 13, 2022
Key Takeaways:
  • Debt consolidation and bankruptcy can both help you get out of debt faster.
  • Bankruptcy takes place through the court system and can reduce the amount that you owe.
  • Debt consolidation restructures your debt but does not reduce your balances.

If you’re worried about debt, you might be considering debt consolidation vs bankruptcy. Debt consolidation means combining multiple debts and making a single payment. You can do this with a consolidation loan or a debt management plan. Bankruptcy means either discharging debt immediately (Chapter 7) or over time (Chapter 13). 

How Debt Consolidation Works

Debt consolidation is the process of combining multiple debts into one. To consolidate your debts, you’d take out a new loan and use its proceeds to pay off your existing accounts. The new loan should provide better terms – like a lower interest rate, a smaller payment, or more time to pay off your debt.

For example, if you have three credit cards with 13%, 14%, and 16% interest rates, you might consolidate them with a home equity loan at a 6% interest rate. 

“Debt consolidation is an option for people who can still make payments on their debt. This type of debt relief combines all of your debts into one monthly payment,” explains Anthony Martin, CEO of Choice Mutual.

Obtaining a personal loan, home equity loan, or balance transfer credit card are among the ways you can consolidate debt and pay off several loans more simply.

“A consumer only has to make a single monthly payment when they pursue debt consolidation, so the debt repayment will be considerably easier and you will be less likely to forget making otherwise multiple payments,” Lyle Solomon, a financial expert, and attorney with Rocklin, California-headquartered Oak View Law Group, says.

Good candidates for debt consolidation

Is debt consolidation a good idea? If you can still afford to make payments on your monthly debt but want fewer monthly bills, you may be a good prospect for debt consolidation.

This move makes sense if the new debt consolidation loan you choose offers better terms than the loans you want to pay off. 

“If you are thinking of using a debt consolidation loan to pay off your debts, there are a few scenarios when it’s worth considering,” notes Solomon. “First, this strategy pays off if you have high-interest debt. Experian data show that the average personal loan interest rate is 9.41%. The typical credit card interest rate, on the other hand, is roughly 16%. Consolidating your debts may allow you to save money on interest charges if you become eligible for a cheaper interest rate than what you are currently paying.”

Debt consolidation is more easily achieved if you have a good to excellent credit score.

“A debt consolidation loan is offered to people with all types of credit. But if you want favorable conditions and a lower interest rate, you’ll need at least a 670 FICO score,” adds Solomon.

Also, because debt consolidation/personal loans have a predetermined repayment schedule, they may be a suitable choice if you’re looking to consolidate debt and stay on a fixed repayment calendar that will give you a target date for total payoff.

“Debt consolidation can be a great way to get out of debt, but it’s important to make sure you can stick to the repayment plan,” cautions Max Benz, founder/CEO of BankingGeek. “If you miss a payment or fall behind, the entire process can quickly become overwhelming.”

Additionally, if you can’t afford to currently pay any amount on your debt owed, “debt consolidation is not for you,” Martin continues.

Debt consolidation loans

Financing vehicles you can use to consolidate debt include a personal loan, home equity loan, or any other type of loan. Once approved, you can utilize the funds to pay off your multiple debts. Or, you can opt for a balance transfer credit card in which you transfer the outstanding balances on your higher-interest credit cards to a new card that offers a lower interest rate.

The advantage of any of these options is that you will pay less in total interest over the life of your new loan/financing than if you did not choose debt consolidation. Plus, it will be more convenient to pay one monthly bill versus several bills.

“Paying your debt consolidation loan payments on time and keeping credit lines open may increase your credit score,” notes Martin. “Making late payments are racking up more debt in the process will lower your credit score, however.”

Debt management plans (DMPs)

If you have challenges paying your unsecured debts each month, a debt management plan (DMP) from a nonprofit credit counseling agency may be the solution you need.

“A DMP program will combine your unsecured debts, such as credit card bills, payday loan payments, medical bills, and utility bills, into a single payment. This can cut your interest rates significantly and provide a structured schedule for paying off the debt over three to five years,” continues Solomon. “Debt management also has a lower impact on your credit score than obligation settlement or bankruptcy because you repay all of your initial debt.”

If you decide to consult with a credit counseling service, a DMP may be one option provided to you. The agency will then work with each of your creditors to develop an affordable payment plan. Once the plan is in effect, you will make a single monthly payment to the credit counseling service, which allocates your funds to your creditors.

“Because you’ll have to pay one payment, a DMP makes debt repayment more manageable. While credit counseling services usually can’t negotiate the amount of the debt with your creditors, they can renegotiate other things like your monthly installment amount or exemptions for any fees you have been imposed,” says Solomon.

If you cannot get a debt consolidation loan, a DMP can be a worthy choice. A DMP doesn’t have any credit criteria, unlike a debt consolidation loan, which often requires a good credit score.

“Choosing a DMP is the best option for both minor and significant debts. However, they aren’t for everyone,” Solomon warns. “A DMP is suitable for you if your unsecured debt is around 15% to 39% of your yearly income if you have a fixed salary and believe you might pay off your debt in five years if you had a cheaper interest rate, and if you can avoid opening any new lines of credit while on the DMP.”

Is Debt Consolidation a Good Idea?

Consolidating debt may or may not be a wise choice.

“It all comes down to how serious you are about the process and whether or not you can commit to seeing it through. If you have a consistent income, decent credit, and a strong desire to wipe off debt, consolidating debts with a personal loan is probably your best option,” Solomon advises. 

“However, if you are not a good candidate for consolidating debt based on the earlier criteria discussed, debt consolidation is not a good idea. This is especially true if your total debt is minimal, if the debt consolidation loan has a higher rate of interest than your outstanding debt, or if the charges for your debt consolidation loan will end up consuming all of your potential savings.”

How Bankruptcy Works

What if your debts have become unmanageable? If you qualify, bankruptcy could reorganize or discharge your debts. The two most common types of bankruptcy for individuals are Chapter 7 and Chapter 13.

Chapter 7

Chapter 7 bankruptcy, aka liquidation bankruptcy, may wipe away some or all of your debt in just a few weeks. However, your income must be low enough to qualify for a Chapter 7 filing. And you may have to give up savings, possessions, and property to satisfy your creditors. 

“Chapter 7 is best if you have a small property, have credit card bills, payday loans, medical bills, and personal loans – which can be forgivable – and if your family’s income is below the state median for a family of your size,” Solomon points out.

Chapter 13

Most people who don’t qualify for Chapter 7 choose to file Chapter 13. In addition, Chapter 13 is the preferred option for consumers who don’t want to lose their assets. To qualify, you need to make minimum earnings and your total unsecured debt cannot surpass $419,275 while your total secured debt can’t exceed $1,257,850.

A Chapter 13 bankruptcy obligates you to pay some or all of your debts over a three to five year period. A bankruptcy judge or trustee examines your income and expenses and determines your monthly plan payment. Once you’ve made all of your plan payments as agreed, the court discharges any remaining balances. 

“Chapter 13 is best if you have a steady source of income, have kept up with your tax filings, and can submit documents of tax returns and payments that are current,” says Solomon.

“You also can’t have exceeded the maximum amounts for secured and unsecured debt. You must not have had a bankruptcy dismissed within 180 days for failing to present in or comply with bankruptcy court, either. And you must not have had a discharge from a Chapter 13 bankruptcy over the previous two years Or a Chapter 7, Chapter 11, or Chapter 12 Bankruptcy within the last four years.”

Bankruptcy counseling

If you feel the need to file bankruptcy, Solomon recommends first attending a counseling session with a credit counseling institution authorized by the Department of Justice’s U.S. Trustee Program. Your counselor should assess your specific financial circumstances, explain bankruptcy choices to you, and help you develop a budget plan. If you cannot afford this counseling, it will be provided at no cost.

“If, after receiving credit counseling, you still want to pursue bankruptcy, it’s best to enlist the help of an experienced attorney, who can assist you in choosing the right bankruptcy option for you,” Solomon notes.

Remember that, “while bankruptcy can be a great way to wipe away your debts and start fresh, it will have a negative impact on your credit,” says Benz.

Bankruptcy Alternatives

When it comes to deciding between debt consolidation vs. bankruptcy, keep in mind that the latter should be your last resort for financial relief.

“In Chapter 7 bankruptcy, you must sell your assets in return for a discharge of most types of debt. With Chapter 13, you will design a payment plan and stick to it to pay back as much of your outstanding debts as possible, and payment arrangements typically last three to five years,” says Solomon.

Alternatively, you may want to consider debt settlement instead of debt consolidation or bankruptcy. Debt settlement involves enlisting the help of a third-party service to negotiate a lower debt repayment than what you owe. Unlike bankruptcy, which creates a public record, debt settlement is private. And unlike bankruptcy, you don’t have to comply with a plan you don’t like. You only settle if you and your creditor agree on an amount and terms.

“Be aware that debt settlement can harm your credit score. And, according to the IRS, the money saved through debt settlement is taxable because it is deemed income to the consumer,” Solomon says. “In addition, debt settlement agencies frequently charge fees based on the debt enrolled or the amount saved.”

We looked at a sample of data from Freedom Debt Relief of people seeking debt relief during June 2024. The data uncovers various trends and statistics about people seeking debt help.

Credit card balances by age group for those seeking debt relief

How do credit card balances vary across different age groups? In June 2024, people seeking debt relief showed the following trends in their open credit card tradelines and average credit card balances:

  • Ages 18-25: Average balance of $7,378 with a monthly payment of $209

  • Ages 26-35: Average balance of $10,797 with a monthly payment of $300

  • Ages 36-50: Average balance of $14,340 with a monthly payment of $405

  • Ages 51-65: Average balance of $14,364 with a monthly payment of $420

  • Ages 65+: Average balance of $14,837 with a monthly payment of $397

These figures show that credit card debt can affect anyone, regardless of age. Whether you're just starting out or nearing retirement, managing credit card debt can be challenging.

Regain Financial Freedom

Seeking debt relief can be the first step toward financial freedom. Are you struggling with debt? Explore options for debt relief to regain control of your finances. It doesn't matter how old you are or what your FICO score or credit utilization is. Take the first step towards a brighter financial future today.

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