Debt Consolidation v. Bankruptcy

Learn about the advantages and disadvantages of debt consolidation and bankruptcy for dealing with debts.

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Debt consolidation and bankruptcy are popular debt management strategies. When you consolidate your debts, you reorganize multiple debt payments into one payment. You can choose to consolidate your debts through a secured loan or an unsecured loan. On the other hand, bankruptcy eliminates or restructures certain debts while under the protection of the federal bankruptcy court. The most common types of bankruptcy cases that individuals and small businesses file are Chapter 7 and Chapter 13. A Chapter 7 bankruptcy case allows you to eliminate many kinds of debt. A Chapter 13 bankruptcy case will enable you to restructure your debts through a supervised repayment plan.

Is debt consolidation or bankruptcy right for you? Each approach has advantages and disadvantages, summarized here and discussed in more detail below. On the positive side, debt consolidation usually allows you to:

  • protect your reputation and credit rating
  • maintain access to credit
  • simplify your debt management by making one payment to one creditor each month instead of multiple payments to different creditors, and
  • get a reduced monthly payment amount.

But you might have to risk losing your home or car, depending on the circumstances, and you could have to pay more overall. With bankruptcy, the pros include getting protection from creditors trying to collect from you and having a fresh financial start after your debts are discharged. On the downside, your credit will take a major hit and you might have to give up some nonessential or luxury items.


What Is Debt Consolidation?

With debt consolidation, you get a single loan to pay off your other loans, leaving you to make just one payment to a single creditor each month rather than making multiple payments to multiple creditors. The goal is to get a lower interest rate, which will reduce the amount you have to pay each month.

Pros of Debt Consolidation

Proponents of debt consolidation often promote this strategy as a simple way to save money and protect your credit rating. Here are some of the advantages of using debt consolidation to manage your debt better.

You'll protect your reputation. Unlike bankruptcy, debt consolidation isn't a matter of public record. Anyone who looks hard enough, including your current or a potential employer, can find out about a bankruptcy. Bankruptcy records are viewable through an electronic subscription service called "Public Access to Court Electronic Records" (or "PACER") or at any federal bankruptcy courthouse.

You maintain your access to credit. Unless the debt consolidation agreement prohibits it, you can keep your credit cards, which might be helpful if an emergency arises. (In most cases, when a credit card company receives notice of your bankruptcy, it will cancel your card.) But if you already owe a significant amount of money or are delinquent in payments, you might not be able to use your credit cards or get approved for additional credit. Also, continued credit card use might defeat the purpose of debt consolidation.

You simplify your debt management. When you consolidate your debt, you no longer have to keep up with multiple payments, at different interest rates, to various creditors. Instead, you make one payment to one creditor.

You get a lower interest rate (hopefully) and reduced monthly payment. If you consolidate your debts, you might get a lower interest rate and a more manageable monthly payment. That way, you'll have more cash available each month to meet your high-priority debts.

Cons of Debt Consolidation

Although debt consolidation has some advantages, it's not an option to take lightly. Consolidating your debts could end up costing you more money in the long run and, if the debt is secured, you could lose some property.

You could lose your property. If you use property such as your home or vehicle as collateral for a debt consolidation loan, you could lose that property if you default on the loan payments. Also, if a lender gives you a debt consolidation loan, the agreement might contain a cross-collateralization clause. This clause allows that lender to take other property it financed if you default on the debt consolidation loan. For example, let's say that you have a car loan through your credit union, and then the credit union gives you a debt consolidation loan. Under the cross-collateralization clause, if you default on the debt consolidation loan, the credit union could repossess your car—even if the car payments are current.

You might have to pay more. Although lower interest rates and reduced monthly payments are appealing, a debt consolidation loan could end up costing you more money. Often, debt consolidation loans help you achieve a lower monthly payment and interest rate in exchange for extending the loan's term (the repayment period). If you stay in debt longer, you might end up paying more interest. Also, a lower interest rate on an unsecured debt consolidation loan might be hard to get if you don't have good credit. Again, interest rates on unsecured loans are generally higher than secured loans. So, the resulting payment might not be low enough to make a difference in your financial situation.


What Is Bankruptcy?

The federal bankruptcy system was designed to give debtors a way to unwind contracts with their creditors. Without a contract, you don't have an obligation to repay the debt—and you get a fresh financial start. Most debtors file one of two types of bankruptcy: Chapter 7 (liquidation) or Chapter 13 (reorganization).

How Chapter 7 Bankruptcy Works

In exchange for a discharge of your debts in a Chapter 7 bankruptcy, you agree that the trustee can take and liquidate (sell) some of your property to pay back debt. But you're allowed to keep (exempt) property that the law protects. Many Chapter 7 filers don't own any nonexempt property, so you might not have to give up anything.

How Chapter 13 Bankruptcy Works

A Chapter 13 bankruptcy reorganizes your debt. You must develop a plan to repay your creditors over three to five years. Most plans will include provisions that allow you to pay creditors less than the amount owed.

Pros of Filing for Bankruptcy

Here are some of the advantages of using bankruptcy to deal with your debt problem.

You get protection from creditors. When you file for bankruptcy, you get the protection of the automatic stay. The stay prohibits most creditors and collectors from engaging in collection activity against you. The automatic stay has the power to stop harassing phone calls, lawsuits, garnishments, repossessions, and foreclosures.

You get a fresh start. Through a Chapter 7 bankruptcy case, you may eliminate most unsecured debt, such as medical bills and credit card debt. You may also surrender real estate or vehicles that you've financed if you don't want to keep those debts. With a Chapter 13 bankruptcy case, you repay a portion of your unsecured debts through the court-supervised repayment plan. And depending on your situation, you might be able to pay for your vehicle at a reduced rate. You can also save your home from foreclosure and your vehicle from repossession.

Cons of Filing for Bankruptcy

Bankruptcy has its drawbacks as well. Here are a couple of them.

You give up some privacy. Your employer might learn about your bankruptcy case if you permit it to pull your credit reports or if your Chapter 13 plan payments are made through payroll deductions. Again, bankruptcy records are available at the federal bankruptcy courthouse where they're filed and through the federal court system's subscription-only PACER service. But as a practical matter, your family and friends are unlikely to find out you've filed bankruptcy unless you owe them money.

You might have to make some sacrifices. You might have to make some sacrifices to qualify for bankruptcy, such as surrendering nonessential or luxury possessions. Also, if you file a Chapter 13 bankruptcy case, you'll be on a strict budget for three to five years, and you can't get credit during that time without the court's permission.


How Debt Consolidation or Filing for Bankruptcy Affects Your Credit

Although a debt consolidation loan will likely show up on your credit reports, as long as you stay current on the debt, it won't typically lower your credit scores much, if at all, under most scoring models. But when you seek new credit in the future, these loans (especially if they're from finance companies or similar businesses) could be viewed negatively by creditors who see them in your credit files because they might imply prior debt problems.

A bankruptcy filing, on the other hand, definitely hurts your credit scores. The damage it will do depends, in large part, on how good your credit was before you file. If you're delinquent on many accounts before you file, your credit will already be already bad. If you then file for bankruptcy, your score will take a dip but not as bad as if your credit was good before filing for bankruptcy. If you file for bankruptcy when your credit is good, your score will take a much bigger hit post-filing. Depending on the type of bankruptcy case you file, the filing may stay on your credit reports for seven to ten years. But filing for bankruptcy might actually help your credit, too, like by improving your debt-to-credit ratio, getting rid of delinquent accounts, and giving you a chance to start rebuilding your credit.


Is Debt Consolidation or Bankruptcy Right For You?

Consider the following questions when deciding whether loan consolidation or bankruptcy is in your best interest.

Can You Afford to Make the Consolidation Loan Payments?

Consolidating your debts won't eliminate any of the amounts you owe. Even if the consolidation loan reduces what you pay monthly, you still have to pay off the total amount of the debt. So, if you don't have a steady income or can't afford the new monthly payment on a consolidation loan, consolidating your debts probably won't help you get back on track.

Will Getting a Consolidation Loan Reduce Your Interest?

One of the main benefits of consolidating your debts is getting a reduced interest rate. Reducing your interest rate allows you to lower your monthly payment and pay less interest over the long term. But if you can't lower your interest rate with a consolidation loan, or if the term is extended so that you'll be repaying the debt for a longer time (see below), then it's probably not worth the extra cost and fees you'll incur consolidating.

Will It Take Longer to Pay Off Your Debt If You Consolidate?

Even if you get a lower interest rate, don't assume that your payment went down solely for that reason. If your new monthly obligation is substantially lower, it usually means a longer repayment term. And if you extend your repayment term, it will probably take you significantly longer to pay off your debt. While it could be nice to have a more manageable monthly payment, you'll most likely pay more interest over the life of the loan.

Is Bankruptcy a Better Option?

If you're already behind on debt payments or have accounts in collection, bankruptcy might be able to help get you back on your feet sooner than debt consolidation. Bankruptcy gets rid of many types of debts and provides you with a fresh financial start. When you reduce your debt load and get your finances under control, you can start making loan and credit payments on time, reduce your debt-to-income ratio, and take other steps to rebuild your credit.


Do I Have Any Other Options?

So long as you have income that you aren't putting towards your basic monthly expenses, you probably have other options for getting out of debt trouble, including:

  • creating a budget and contacting creditors yourself to arrange a solution, like a reduced interest rate, a lower minimum payment, or the removal of late penalties or other fees
  • settling your debts for less than you owe on your own or with the help of a legitimate credit counseling agency or lawyer (avoid debt settlement companies, though), or
  • entering into a legitimate debt management plan.

Getting Help

If you need help deciding which route to take, consider talking to a nonprofit credit counseling agency. Credit counseling agencies offer financial assistance, including debt management plans and debt consolidation advice, for free or at a minimal charge. These agencies also provide credit counseling, budgeting guidance, and debt management advice at no or low cost. But be sure you're dealing with a reputable, nonprofit agency—not a for-profit scammer. To find a legitimate credit counseling agency, consider using a member of the National Foundation for Credit Counseling (NFCC).

You might also consider talking to a lawyer to learn about different options for dealing with your debt, including debt settlement and debt consolidation. To learn more about whether filing for bankruptcy might be suitable for your situation, consider talking to a bankruptcy attorney.

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