Debt Consolidation vs. Bankruptcy: Which Is Right for You?
Consolidating debt can help you get a lower interest rate, but you’ll still have to pay what you owe. Bankruptcy might eliminate your debt, but it can drop your credit score as much as 200 points. It’ll also appear on your credit report for seven to 10 years.
Debt consolidation and bankruptcy aren’t reversible — once it’s done, it’s done. So although both options can help you take control of your finances, it’s critical you know the differences between the two.
What is debt consolidation?
Debt consolidation is the act of replacing multiple smaller debts for one larger debt. It doesn’t make your debt disappear. Instead, it reorganizes it.
Borrowers who consolidate usually do so for two main reasons. The first is to get a lower interest rate. If you have excellent credit, chances are you’ll get a lower rate on a credit card refinancing loan than what you carry on your current credit card balances.
People also consolidate when they want to reduce the number of bills they pay each month. After you consolidate, you’ll only be responsible for one monthly debt bill.
Debt consolidation loans are among the most popular ways to consolidate. These are personal loans, and they’re typically unsecured (meaning they don’t require collateral). To make things easier, your lender might even send your loan to your individual creditors on your behalf.
Personal loans aren’t the only way to consolidate debt. You could also use a:
Balance transfer credit card
A balance transfer credit card is designed for debt consolidation. Here, you’ll transfer the debt on your current cards to the balance transfer card. The upside here is the no- or low-interest introductory period on balance transfer cards. These usually range between 12 and 21 months.
Unfortunately, though, you could be on the hook for a balance transfer fee between 3% and 5%. You should also pay your debt in full before the end of the introductory period. Otherwise, you’ll pay interest on your remaining balance.
Home equity loan
The difference between what you owe on your home and what it’s worth is your equity. A home equity loan (also called a second mortgage) lets you borrow from that amount. You could then use those funds to pay off your debt.
Home equity loans and lines of credit (more on that below) are secured loans that use your house as collateral. It’s imperative that you pay back your home equity loan or line of credit. Otherwise, your lender can foreclose on your home.
Home equity line of credit
A home equity line of credit (HELOC) also allows you to borrow against the equity in your home. But instead of getting your funds as a lump sum, you’ll be able to borrow over and over again. Paying off what you borrowed opens up credit you can use later on. These work similarly to credit cards.
Also unlike most debt consolidation and home equity loans, HELOCs usually have variable interest rates. Variable rates are tied to the market and can be risky when inflation is high.
You have a manageable amount of debt: Debt consolidation only works if you can afford your debt. Consolidating doesn’t get rid of what you owe, but you might save on interest.
You’re juggling multiple monthly payments: When you owe three or more creditors, it’s easy to let a bill slip through the cracks. After you consolidate, you’ll only have one monthly payment.
You have good to excellent credit: Bankruptcy ruins your credit score. If you have strong credit, you may want to protect it by consolidating. Also, borrowers with excellent credit tend to get lower rates on consolidation loans than on credit cards.
You’re ready to stop using your credit cards: If you continue to rack up debt after consolidating, you’ll likely end up worse off. Debt consolidation makes the most sense for those who are able to make a lifestyle change.
What is bankruptcy?
Bankruptcy is a legal process that can reduce, restructure or eliminate your debt.
There are different types of bankruptcies. Some are for individuals, and some are for corporations. Depending on the type of bankruptcy you file, you might lose many of your assets.
Bankruptcy should be a last resort. It can be difficult to get a mortgage after bankruptcy. The same goes for getting a car loan, renting a home and in some cases, securing a job. Still, it can provide a fresh start if you’re truly out of options.
Chapter 7 bankruptcy
Chapter 7 bankruptcy requires that you sell nonexempt assets and use those funds to pay your debt. Nonexempt assets could include a second home, luxury items, collectibles or investments. This is also known as liquidation bankruptcy.
If your nonexempt assets won’t completely cover what you owe, the courts may discharge your remaining debt. Once the court approves your Chapter 7 filing, it will typically appear on your credit report for 10 years.
To qualify for Chapter 7, you must pass a means test. This will measure things like your monthly income, expenses and level of debt. Essentially, you must prove that you’re unable to pay back your creditors.
You’re certain you can’t afford your level of debt: You should only consider bankruptcy if your debt far surpasses your ability to pay it back.
You earn little to no disposable income: If you have a lot of savings or disposable income, you might not pass the means test.
You own few to no assets: You may have to sell valuable property when you file for Chapter 7. If you have a lot of assets, Chapter 13 could be a better choice.
Your debt qualifies as dischargeable: Not all debt qualifies for discharge under Chapter 7. Some examples include alimony, child support and most federal student loans.
Chapter 13 bankruptcy
Chapter 13 bankruptcy (also called the wage earner’s plan) helps overwhelmed borrowers get out of debt in three to five years with the help of a repayment plan. As soon as the court approves the repayment plan, creditors must stop most garnishments and collections.
Unlike Chapter 7, you don’t have to sell your assets when you file for Chapter 13. You will, however, still need to pay what you owe (at least, partially). A bankruptcy judge and your creditors must approve your proposed payment plan for you to qualify.
Chapter 13 can have a negative impact on your credit for seven years — three years less than Chapter 7.
You can pay back your debt (with the help of a repayment plan): Only those with a regular income and can pay back most or all of what they owe in three to five years qualify for Chapter 13.
You have assets to protect: Chapter 13 may be a better choice for people who’d rather not sell their nonexempt assets.
You didn’t pass the Chapter 7 means test: If you earn above the median income in your state or have a moderate amount of disposable income, you likely won’t qualify for Chapter 7.
Your debt doesn’t exceed Chapter 13 limits: Currently, you must have no more than $2.75 million in debt to qualify for Chapter 13. However, this is due to a temporary ruling. Unless that temporary ruling is extended, only those with $1,395,875 or less in secured debt and $465,275 of unsecured debt will qualify (effective June 2024).
Debt consolidation vs. bankruptcy: pros and cons
| Debt consolidation | Chapter 7 bankruptcy | Chapter 13 bankruptcy | |
|---|---|---|---|
| How it works | Combines multiple existing debts for one new debt | Court-ordered sale of nonexempt assets to pay off debt | Court-approved repayment plan to get out of debt in three to five years |
| Pros | Might protect (or even help) your credit score Could help you pay less overall interest Can streamline budget | Will no longer have to pay dischargeable debt Stops most collections and garnishments Process typically only takes four to six months | Don’t have to sell assets May reduce the total amount of debt you owe Stops most collections and garnishments |
| Cons | Is just another form of debt May not be affordable if you have fair credit or worse Could require collateral | Not everyone will pass the means test Severely damages credit score Can show on your credit report for 10 years | Required to repay at least some of your debt Court and creditors must approve your repayment plan Can negatively impact credit for seven years |
How does bankruptcy and debt consolidation affect your credit?
Initially, your score will probably drop a bit after taking a consolidation loan. You’ll almost certainly be required to take a hard credit pull when applying for your loan. This can negatively impact your score (albeit usually minimally and temporarily).
But by making your consolidation payments on time (every time), you’ll likely see your credit score improve. If this is your only loan, you could also improve your credit mix, which makes up 10% of your score.
Bankruptcy is a different story. No matter if you’re filing for Chapter 7 or 13, expect a dramatic drop in your credit score. But since you’ll be paying back all or some of your debt, future creditors may be more willing to work with you if you filed Chapter 13 versus Chapter 7.
Remember, Chapter 7 bankruptcy stays on your credit reports for 10 years, and Chapter 13 for seven years.
Deciding between bankruptcy vs. debt consolidation
Personal finance is exactly that — personal. Whether bankruptcy or debt consolidation is right for you depends on your income, assets, credit score and current debt. Get started by asking yourself the questions below:
- Can I pay my debt? → Debt consolidation
- Is my credit score worth protecting? → Debt consolidation
- Do I qualify for a low APR on a personal loan? → Debt consolidation
- Is my debt insurmountable? → Chapter 7 or Chapter 13 bankruptcy
- Do I have little to no disposable income? → Chapter 7 bankruptcy
- Do I have a lot of nonexempt assets to lose? → Chapter 13 bankruptcy
- If my debt were reduced, could I pay it off in three to five years? → Chapter 13 bankruptcy
Bankruptcy is a serious matter, and it’s best to speak with an attorney before making any decisions.
Alternatives to debt consolidation and bankruptcy
Before committing to debt consolidation or bankruptcy, you must review all options. Although these strategies can be effective, they will impact your credit score for years to come. Perhaps the alternatives below make more sense for you.
Debt management plan
Before you can file for bankruptcy, you have to go through credit counseling. Even if you aren’t planning on filing, you may want to meet with a certified counselor anyways. These professionals usually work at nonprofit organizations for little to no cost.
Among the many things a credit counselor can help with, one is coming up with an official debt management plan. With this, your counselor will negotiate with your creditors on your behalf and devise a plan to get you out of debt within three to five years.
Creditor negotiation
Something is better than nothing. That’s why some creditors might reduce your amount of debt as long as you make some sort of minimum payment. There’s no guarantee that your creditors will reduce your debt via negotiation, but it doesn’t hurt to try.
Debt settlement
Debt settlement companies are for-profit businesses that attempt to negotiate with your creditors. In theory, they will ask your creditors to reduce your debt as long as you make a lump sum payment.
However, there’s no guarantee that your creditors will work with a debt settlement company. Plus, debt settlement can hurt your credit, since it requires that you’ve been delinquent for a long time. You must also have the funds to make a large lump sum payment and pay a fee to the debt settlement company.
Frequently asked questions
That depends on your financial situation. If you’re able to pay what you owe and qualify for a low rate on a personal loan, it makes more sense to consolidate your debt. Consolidating shouldn’t tank your credit score like bankruptcy will.
But if you have an unmanageable amount of debt, bankruptcy might provide a much-needed clean slate. That is, as long as you’re at peace with the ramifications: a severely damaged credit score and possible loss of assets.
The act of debt consolidation itself doesn’t appear on your credit report. However, taking a debt consolidation loan will. Late payments on your consolidation loan can appear for seven years. Once you’ve paid off your loan, it can remain on your report for 10 years.
That doesn’t mean that consolidating will hurt your credit. On the contrary, making on-time debt consolidation payments can improve your credit score.
Credit-wise, yes, a debt management plan is better than bankruptcy. But you usually cannot use your credit cards while under a debt management plan. You’ll also need to pay some or all of your debt, something that is not possible for everyone.