Debt Consolidation vs. Bankruptcy: How To Choose

Debt consolidation and bankruptcy are two options for getting out of debt, but they can have drastic consequences for your financial future. Debt consolidation involves paying off your debts with a new loan, with the goal of getting a lower annual percentage rate (APR), and may actually improve your credit over time.

Bankruptcy allows you to wipe away certain debts. But it’s considered a last-resort option since it can have a catastrophic impact on your credit.

Compare personal loan rates

Debt consolidation vs. bankruptcy: What to know

Debt consolidation is an option for repaying your combined debts at a lower interest rate. Unlike bankruptcy, it doesn’t reduce what you owe. But it can reduce the interest you’re required to pay, which can help you get out of debt faster or make payments more affordable. If you consolidate your debt with a personal loan, the process can be quick and easy.

However, if you’re overwhelmed with debt and can’t afford the monthly payments on a new loan, or if you have poor credit, debt consolidation may not be an option for you. You may want to consider a debt management plan through a credit counselor, for example, or a more extreme solution.

Bankruptcy is a legal process that may require you to hire an attorney and pay upfront filing fees. The total cost to file can range from $400 to $3,000, according to the nonprofit Upsolve, which offers a free online bankruptcy filing tool for eligible debtors. Bankruptcy has the potential to erase most of your debts. But it’s important to understand that bankruptcy can significantly lower your credit score, which can make it difficult to buy a home or get an auto loan for up to 10 years.

How does debt consolidation work?

Debt consolidation involves combining your debts so that you only have one monthly payment. The process typically relies on low-interest financial products, like 0% introductory APR credit cards, home equity loans, or personal loans, to manage higher-interest existing debts, like credit card debt or payday loans.

For example, you might take out a personal loan and use the money to pay off your credit card debt. Instead of paying interest on your credit cards, the average interest rate on which was 21.37%, according to the Federal Reserve, you’d only have to worry about one monthly payment on your personal loan. Two-year personal loans had an average rate of 11.66%, according to the Fed, so using this strategy could mean paying less money in interest over time. With less to pay back, you can pay down your debt faster.

Learn More: How Much Credit Card Debt Is Too Much?

Pros and cons of debt consolidation

How does bankruptcy work?

Individuals generally have two options when it comes to filing for bankruptcy:

• Chapter 7 bankruptcy: To qualify for Chapter 7 bankruptcy, you’ll need to meet certain income limits. Once you file, collection attempts should come to a halt. Your bankruptcy trustee will liquidate your nonexempt assets to pay your creditors. Any remaining debt is discharged, typically within 90 days of the first meeting with your creditors, which means you won’t be responsible for repayment.
• Chapter 13 bankruptcy: You’re generally eligible for Chapter 13 bankruptcy if your unsecured debts are less than $2.75 million. Filing stops most collection attempts. Instead of offering immediate discharge, Chapter 13 bankruptcy allows you to protect your assets while entering into a repayment plan that lasts 3 to 5 years, depending on your income. Any remaining debts will be discharged once you reach the end of the repayment term.

Both types of bankruptcy can badly damage your credit. Chapter 13 bankruptcy remains on your credit report for seven years, while Chapter 7 bankruptcy stays on your report for up to 10 years. It's often best to hire an attorney to handle the bankruptcy process.

Pros and cons of bankruptcy

Other debt management options

Here are some other options to consider if debt consolidation or bankruptcy is not right for you.

• Debt avalanche method: The debt avalanche method is a strategy for getting rid of debt that doesn’t require help from a lender. It involves making the minimum payments on all your debts and putting any extra money you have toward your highest-interest debt. Once it’s paid, you move on to the next debt with the highest interest rate. This method can save you the most in interest, but it can take a while.
• Debt snowball method: The debt snowball method requires you to put any extra money toward your smallest debt, while continuing to make minimum payments on your other debts. Once your smallest debt is paid off, you’ll apply that monthly payment toward the next debt and so on, until it creates a snowball effect and your debt is paid off. This method is best for those who like to see quick progress.
• Balance transfer card: This option transfers your balance from one credit card to another, often with a 0% introductory APR. You can make monthly payments toward paying off your debt, without interest accruing, which allows you to pay off your debt faster. But keep in mind that once the promotional period ends, the standard APR will resume on any remaining balance. Also, some cards charge a balance transfer fee that's typically 3% to 5% of the amount you're transferring.
• Home equity loan or HELOC: With either of these options, you can borrow against the equity in your home. A home equity loan is an installment loan, while a home equity line of credit (HELOC) is a type of revolving credit. Both are secured by your home, so if you can’t make your payments, you could face foreclosure.

• Credit counseling: A nonprofit credit counselor can help you with your budget and even enroll you in a debt management plan, which can reduce the interest and fees on your debts and lower your monthly payments. A debt management plan only requires one monthly payment to the credit counseling agency. Make sure to choose an approved agency.

Related:

• Debt Consolidation vs. Balance Transfer
• Personal Loan vs. 0% APR Credit Card