In these challenging economic times, debt consolidation and bankruptcy are popular debt management strategies. Is debt consolidation or bankruptcy right for you? To find out, learn about the advantages and disadvantages of each approach.
(To learn about other ways to deal with debt, visit our Debt Management topic area.)
Proponents of debt consolidation often promote this strategy as a simple way to save money and protect your credit rating. When you consolidate your debts, you reorganize multiple debt payments into one payment. You can choose to consolidate debt through a secured loan or an unsecured loan. (To learn more about the types of debt consolidation, visit Nolo’s Debt Consolidation topic area.)
Here are some of the advantages of using debt consolidation to better manage your debt.
Protect your reputation and credit rating. Unlike bankruptcy, debt consolidation is not a matter of public record. Anyone who looks hard enough will find out about your bankruptcy. Bankruptcy records are viewable through an electronic subscription service called PACER or at any federal bankruptcy courthouse. Although a debt consolidation loan may show up on your credit report, it does not typically lower a credit score like a bankruptcy filing does.
Maintain your access to credit. Unless prohibited by the debt consolidation agreement, you can keep your credit cards. This may be helpful should an emergency arise. However, if you already owe a significant amount of money or are in default, you may not be able to use your credit cards or be approved for additional credit. Also, continued credit card use may defeat the purpose of debt consolidation.
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 convenient payment.
Lower interest rate and monthly payment. If you consolidate your debts, you may be able to obtain a more manageable monthly payment, with a lower interest rate. As a result, you will have more cash available each month to meet your high priority needs.
Although there are some advantages to debt consolidation, it’s not an option to take lightly. You could end up costing you money in hidden fees and tax liability. And more important – you could lose property.
You could lose your property. If you use property such as your home or vehicle as collateral for the 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, there may be a cross-collateralization clause that allows that lender to take other property it has 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. (Learn more about cross-collateralization.)
Beware of hidden costs. Although lower interest rates and 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 repayment period. If you stay in debt longer, you may end up paying more over the long term.
Negative tax consequences. Depending on your financial condition, any money you save from debt relief services such as debt consolidation may be considered income by the IRS, which means you pay taxes on it. Credit card companies and other creditors may report settled debt to the IRS, which the IRS considers income.
Through bankruptcy, you may eliminate or restructure 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 types of debt. A Chapter 13 bankruptcy case allows you to restructure your debts through a supervised repayment plan. (To learn more about the differences between these types of bankruptcy, see our Bankruptcy topic area.)
Here are some of the advantages of using bankruptcy to deal with your debt problem.
Protection from creditors. When you file for bankruptcy, you get the protection of the automatic stay. The automatic 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. (To learn more about the automatic stay, see our Bankruptcy’s Automatic Stay topic area.)
You get a fresh start. Through a Chapter 7 bankruptcy case, you may eliminate most unsecured debt such as medical bills and credit cards. You may also surrender real estate or vehicles that you have financed if you don’t want to keep those debts. (To learn more about which debts can be discharged, read Which Debts Are Discharged in Chapter 7 Bankruptcy?)
Through 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 may be able to pay for your vehicle at a reduced rate. You can also save your home from foreclosure and vehicle from repossession.
Bankruptcy has its drawbacks as well. Here are a few:
Negative impact on credit rating. A bankruptcy filing lowers your credit score. Depending on the type of bankruptcy case you file, the filing may stay on your credit report for seven to ten years. However, if you already owe a significant amount of money, you may already have a poor credit rating, especially if you are in default. Once you receive your bankruptcy discharge, you will have a clean slate. Some creditors even actively solicit recent bankruptcy debtors because they know that there are time limits on filing for bankruptcy again.
You may have to make some sacrifices. You may have to make some sacrifices in order to qualify for bankruptcy, such as surrendering nonessential or luxury possessions. Also, if you file a Chapter 13 bankruptcy case, you will be on a strict budget for three to five years and you can’t obtain credit during that time without the court’s permission.
Privacy and reputation. Your employer may learn about your bankruptcy case if you permit it to pull your credit report, or if your Chapter 13 plan payments are made through payroll deductions. (To learn whether your employer can fire you because of your bankruptcy, see Post-Bankruptcy Discrimination: Is It Legal?)
Bankruptcy records are available at the federal bankruptcy courthouse where they are filed and through the federal court system’s subscription-only PACER service. However, as a practical matter, your family and friends are unlikely to find out you’ve filed bankruptcy unless you owe them money.