Debt Consolidation vs. Bankruptcy: Which Path Gets You Out of Debt?

Bankruptcy and debt consolidation are two major methods that are well organized towards helping debtors achieve financial freedom from debts. However, bankruptcy is appropriate when the numbers simply do not add up;

when your debt is greater than your income and repayments within a period of five years would be too challenging. Debt consolidation is applicable where the debtor has manageable amounts of debt and his credit score is above 550.

What Is Debt Consolidation?

Debt consolidation works by combining various loans into one loan that carries a lower interest rate. Rather than trying to meet five deadlines each month, you will pay only one bill.

The technique is specifically aimed at tackling costly debts such as credit card loans. The new lender repays all your previous creditors, and you settle the new loan within a stipulated period of three to five years.

There are no guarantees here. However, debt consolidation can be quite useful for someone whose salary can handle the monthly repayment burden.

Who Debt Consolidation Works Best For

A debt consolidation strategy should be considered where:

• You have a credit score of 550 or higher (the highest savings come with a credit score above 670)

• You earn enough to sustain fixed monthly payments

• You will realistically repay your debts within a period of three to five years

• You would like to preserve your assets and make the process confidential

Pro Tip:

Prior to seeking debt consolidation, make a list of all your debts including balance owed, interest rate, and monthly minimum payment due. Calculate your average weighted interest rate. In order to save money, any good debt consolidation loan must offer an interest rate lower than that.

Pros and Cons of Debt Consolidation

Pros:

• One monthly payment simplification

• An interest rate that could potentially be lower

• No effect on your assets

• Opportunities to build credit score with payments

Cons:

• Minimum requirement for credit score to receive this kind of loan is 550

• Usually comes with fees between 1%-8% of the amount borrowed

• Balance transfer fee could be between 3%-5%

• Could result in building new debt if your spending is unchanged

What Is Bankruptcy?

It is a process where the person receives protection from creditors through the courts, while their debts are either eliminated or reorganized. For most people, bankruptcy will always boil down to Chapter 7 and Chapter 13.

Chapter 7 (liquidation)

It is a fast process taking three to six months to complete. Some of the non-exempt properties might be sold to pay the creditors back, but all unsecured debts are dischargeable. Not all individuals are eligible for this type of bankruptcy. In 2005, Congress added a means test to ensure Chapter 7 is only available to people who cannot afford to repay their debts.

Chapter 13 (reorganization)

Allows the person to keep their properties while adhering to the payment plan that lasts between three to five years. The individual must demonstrate sufficient monthly income to support the payment plan.

The two types of bankruptcy require credit counseling approved by NFCC, payment of court costs, and most likely having an attorney on board.

"First of all, you need to consider the pros and cons of math over psychology. In case your finances are not in such a position that either the avalanche or the snowball approach will be able to pay off the total amount of your debt within five years, then you don’t need a debt management approach. You need legal protection that only bankruptcy will offer you."

Ashley Morgan, Ashley F. Morgan Law, PC

Who Bankruptcy Works Best For

Bankruptcy is the way to go when:

• There is already wage garnishment, lawsuits from creditors, or threats of foreclosure

• You have more than $60,000 of unsecured debts, which cannot be paid off in five years

• Your credit score is too low to get a consolidation loan

• Your monthly income is not sufficient enough for a debt management approach

Once you declare bankruptcy, an automatic stay is placed on you, meaning that all collection efforts are put to a stop.

Pros and Cons of Filing for Bankruptcy

Pros:

• Collection proceedings cease instantly, including harassment and foreclosure

• The majority of unsecured debts may be wiped clean

• Protection against creditors enforced by the court during the entire procedure

• An opportunity for a fresh start financially

Cons:

• Remains on credit report for 7 to 10 years

• Risk of losing nonexempt assets when filing for Chapter 7

• Trouble in qualifying for financing or mortgage in the future

• Court fees range between $313 to $338, lawyer fees from $1,000 to $6,000

• Credit counseling is needed beforehand

Debt Consolidation vs. Bankruptcy: Key Differences

These two options diverge in five important ways.

Eligibility

For debt consolidation, there is a need for a minimum of a 550 credit score. For bankruptcy, there are no minimum credit score prerequisites, except for Chapter 7 where there is an upper limit to the means test, while Chapter 13 necessitates the ability to pay back debts.

Credit Score Impact

Both affect your credit scores, though differently. Debt consolidation loans will cause only a small fall in your score, three to five points due to the hard inquiry that usually disappears after 12 months. You might even increase your credit score by making timely payments within six to twelve months.

Bankruptcy affects your score more than debt consolidation does. The effect lasts for ten years if you declare Chapter 7 bankruptcy, which is seven years in case of Chapter 13. The drop can be between 100 and 200 points right after the bankruptcy filing. As per guidelines from CFPB, both types of bankruptcies are derogatory marks for the entire reporting period.

Timeline

Consolidation takes three to five years of payments to be over, whereas a Chapter 7 bankruptcy takes three to six months. On the other hand, Chapter 13 takes three to five years to be completed.

Asset Protection

While debt consolidation won't touch your assets, Chapter 7 may result in selling some of your assets. On the other hand, Chapter 13 allows you to repay the debt while keeping your assets safe.

Privacy and Social Impact

Lastly, debt consolidation is a private financial agreement, while bankruptcy is a public one.

Cost Comparison: What You'll Actually Pay

Attorney fees vary by location and case complexity. Always verify current court filing fees at uscourts.gov.

Pro Tip:

Do not miss out on the free consultation with an attorney for the bankruptcy process. It is advisable that you hire an attorney because many cases are won with the aid of a lawyer; especially considering state-specific exemptions.

How Each Option Affects Your Credit Score Long-Term

Debt Consolidation Credit Impact

• Impact of hard inquiries during the application process: deducts three to five points; disappears after 12 months

• Creation of a new account negatively affects average account age

• Repaying revolving credit accounts lowers credit utilization ratio; one of the fastest ways to raise credit score

• Making timely repayments establishes positive payment history after six to twelve months

• Overall impact: neutral to positive after six to twelve months of timely repayments

Bankruptcy Credit Impact

• Chapter 7 bankruptcy stays on record for 10 years starting from the filing date

• Chapter 13 bankruptcy stays on record for 7 years starting from the filing date

• Immediate drop in credit score by 100 to 200 points

• Getting back to fair score range (580 to 669) takes about two to three years

• Getting back to good score range (670+) takes about four to five years

"First and foremost, before paying off debt, one needs a budget. It helps to track all expenses and determine whether it is possible to save on some things or earn more money so that we can pay the debt off." 

Ashley Morgan, Ashley F. Morgan Law, PC

How to Move Forward With Your Chosen Option

If You Choose Debt Consolidation

1. Your FICO score should be calculated at AnnualCreditReport.com. It has to be not lower than 550 and preferable to be higher than 670.

2. Prepare the list of your debts specifying the amount of debt and APRs for each of them to calculate your current weighted average interest rate.

3. Pre-qualify yourself at least three different banks without affecting your FICO score.

4. Choose the one with the lowest interest rate and fewer fees making sure that its payment would fit your budget.

If You Choose Bankruptcy

1. Finish your NFCC-approved credit counseling program in a period of no more than 180 days prior to filing. Both Chapter 7 and Chapter 13 require that.

2. Visit a bankruptcy lawyer. They typically offer a complimentary first consultation and help navigate the exemptions for their respective states.

3. Decide which bankruptcy chapter is appropriate. The means test must be passed in Chapter 7. The proof of sufficient income comes into play for Chapter 13.

4. File your bankruptcy papers in court, attending the 341 Meeting of Creditors.

Frequently Asked Questions

What's the difference between debt consolidation and debt settlement?

Debt consolidation merges all your debts into a single loan, where you pay off your entire balance with new terms. In contrast, debt settlement involves negotiating with creditors for a payment below the total debt, which requires defaulting and results in severe damage to your credit score.

Debt consolidation, on the other hand, is considerably safer for your credit rating.

How soon can I buy a house after bankruptcy vs. debt consolidation?

A Chapter 7 filing usually takes four to seven years before a person qualifies for a regular mortgage. In case of Chapter 13, one must wait two to four years post-filing.

However, through debt consolidation, one could become eligible for a mortgage after 12 to 24 months of on-time payments, assuming their debt-to-income ratio is within acceptable levels.

What happens if I miss my consolidation payments?

If payments are missed, the loan will automatically default, causing further credit score damage and triggering collection activities. If you find yourself unable to make any payments, contact your lender as soon as possible. If you are unable to pay for reasons beyond temporary ones, then you should consider filing for bankruptcy again.

Conclusion on Debt Consolidation vs. Bankruptcy

There's no one-size-fits-all response in deciding between debt consolidation or bankruptcy; it all depends on your individual circumstances.

If you are able to manage your debt, have a decent credit rating, and are able to pay off what you owe within three to five years, then debt consolidation may be a safer approach. However, if you find yourself with too much unsecured debt, threatened by creditors, and with income levels that aren't enough to cover your liabilities, then bankruptcy may be a better route.

Consult with a bankruptcy lawyer or an NFCC member credit counselor before you decide which course of action is best for you. It costs nothing to do a proper consultation and have someone look at your debt-to-income ratio without bias.