Debt Consolidation vs. Bankruptcy: Which Is Best for You?

You may be able to climb out of debt with a debt consolidation loan or clear it more quickly by filing for bankruptcy. But one may be much better than the other for your situation — and it’s not the same for everyone. Use this guide to understand how each process works, its impact on your credit, and under what circumstances you might pursue debt consolidation over bankruptcy and vice versa.

How debt consolidation loans work

Debt consolidation allows you to roll several debts into a single loan for more manageable payments and a potentially lower interest rate and/or monthly payment. It has several advantages: 

• You make one payment each month instead of several
• You could lower your interest rate
• You could lower your monthly payment
• You could quickly improve your credit by reducing your credit utilization
• You can avoid compound interest, in some cases

However, depending on the loan's repayment term, you may pay more interest over time, and it could take longer for you to pay off all your debt.

Here's an example: Say you have a credit card balance of $8,000 at 29.99% APR, a second credit card balance of $5,000 at 15% APR, and a $2,000 department store card balance at 32.99% APR. You can afford to pay $400 per month.

Scenario 1 (no debt consolidation)

It would take around six years for you to pay off all three cards at $400 per month — if you’re being strategic and pay off the debt with the highest interest rate first. You’d probably pay between $14,000 and $15,000 in interest, depending on each account's minimum payment. 

Scenario 2 (debt consolidation)

If you qualify for a five-year debt consolidation loan with a 25% APR, you might choose to consolidate the balances on your two cards with higher APRs (the $8,000 balance at 29.99% APR and the $2,000 balance at 32.99% APR). In this case, your new monthly payment on the debt consolidation loan would be around $294, which leaves $106 to put toward the remaining credit card — so, your net monthly payment would be the same for the first five years at $400. 

But after five years, the debt consolidation loan would be paid off. So, in the sixth year, you’d pay only $106 each month to finish paying off the remaining credit card (if you didn't consolidate, you'd still be paying $400 per month through the sixth year). And you’d pay only $10,211 in total interest, saving up to around $5,000.

Although the examples above use credit cards, you can consolidate other types of debt.

Debt consolidation loan rates for bad and fair credit

The APRs below represent average personal loan rates that borrowers using the Credible marketplace over the past 12 months received for debt consolidation or credit card refinancing.

Pros and cons of debt consolidation loans

How bankruptcy works

Bankruptcy can discharge your debts, either within a few months or after a certain number of years on a court-approved payment plan. An immediate benefit to filing for bankruptcy is the automatic stay, which stops most lawsuits, wage garnishments, collection phone calls, and other collections activity. The stay usually lasts while the case is pending in federal court. What happens next depends on the type of bankruptcy you file: Chapter 7 or Chapter 13.

Chapter 7

Chapter 7 is the most common type for individuals. “It is typically what you think of when considering bankruptcy,” says Ashley F. Morgan, attorney and owner of Ashley F. Morgan Law, PC, a law office focused on bankruptcy and debt management solutions. “It is a three- to four-month process that wipes away as much debt as possible.”

To qualify for Chapter 7 bankruptcy, your income needs to be below a certain threshold. (If it’s not less than your state’s median income, you’ll need to pass a means test.) After you file, a court-appointed trustee reviews your filing and holds a meeting to verify your information and move the case forward. The trustee also sells any non-exempt property, like a vacation home or extra vehicle, to pay off debts, while the remaining (exempt) debts get discharged — which means you won’t be responsible for repayment. Note that some debts, like alimony and child support, are not dischargeable through bankruptcy. 

Chapter 7 bankruptcy generally stays on your credit report for 10 years after filing.

Chapter 13

With Chapter 13 bankruptcy, you can protect your assets while entering a repayment plan to pay off your debts — typically over three to five years. To qualify, your unsecured debts must be less than $526,700, and secured debts must be less than $1,580,125 as of the filing date. After completing the payment plan and a financial management course, the court may discharge your remaining outstanding debts.

Morgan adds that selling assets after filing Chapter 13 may require court approval. You also may need trustee approval before taking on new debt throughout the process. After filing, a Chapter 13 bankruptcy remains on your credit report for seven years.

Pros and cons of bankruptcy

Similarities and differences

Here's how debt consolidation and bankruptcy stack up:

Impact on credit

Debt consolidation loans and bankruptcy can affect your credit score, but in different ways.

Debt consolidation

When you apply for a debt consolidation loan, the lender usually conducts a hard credit check, which can cause your score to dip by a few points. The drop can impact your score for up to a year, though a hard inquiry appears on your report for two years. The biggest impact on your score happens once you get the loan. 

If you’re using an installment loan, like a personal loan, to pay off credit card debt, you could see your score rise quickly and significantly. This is because you’d reduce your credit utilization once the cards are paid off, and credit utilization contributes up to 30% to your FICO score. If you make payments on time each month, you should see your credit score further improve over time. 

But your other spending habits matter, too. Howard Dvorkin, a CPA, debt solutions author, and the founder and chairman of Debt.com, warns against being frivolous with spending after consolidating, especially with credit cards. “If you’ve successfully emerged from debt consolidation, you don’t want to undo everything you just accomplished,” says Dvorkin. “Never use a credit card to spend money you don’t have. Consider your plastic as a cash replacement, not a floating loan.” Otherwise, you might end up in another debt cycle.

Bankruptcy

With bankruptcy, “The credit score hit is relative,” says Morgan. “If you have perfect credit, you see a drop. But if you are already 90 to 180 days behind on debt payments, you likely will see an improvement on your credit.”

However, bankruptcy remains on your credit report for up to 10 years, and can affect your ability to qualify for new loans, a mortgage, a place to rent, and even a job — especially for the first few years. Potential creditors, landlords, and employers will typically see a bankruptcy as a black mark on your credit, even if your actual score has improved post-filing.

Which is the better choice?

Which option is best for your current situation? Consider these scenarios when debt consolidation might make more sense than bankruptcy, and vice versa. 

When debt consolidation make more sense

A debt consolidation loan may be the best option when you:

• Can afford a lower monthly payment: If you have income to put toward debt payments, but your current payments are too high, you could potentially lower them with a long-term debt consolidation loan. 
• Still have good credit: If your credit hasn’t suffered from one or more past-due accounts, you could potentially qualify for a lower rate than what you’re paying now (especially if you have credit card debt), thereby saving money and lowering monthly payments.
• Want to improve your credit score: By consolidating credit card debt with an installment loan, you could see credit score gains within one month. While lowering your monthly payment so it’s more affordable could help you avoid late payments, which could also improve your score. 
• Have an emergency situation or expense: “If you got into debt because of an accident, illness, or natural disaster, a debt consolidation loan can bridge the gap until you get back on your feet,” says Dvorkin. 

Scenarios when bankruptcy makes more sense

Bankruptcy is often a last-resort decision once debt collection activity has started. Consider it when:

• Other debt payment strategies haven't worked: “If someone has been trying to pay down debt and has seen no progress for a year, then bankruptcy may make sense,” says Morgan. This is especially true if a person doesn't predict any increases to their income in the foreseeable future, which could make it easier to pay off debt. 
• A financial reset could get you back on track: If a long jobless spell, medical issues, or other situation has led to overwhelming, runaway debt, a clean slate could allow you to rebuild your savings and credit. 
• You have bad credit and low income: If your credit score has already suffered and you don’t expect your income to change, a bankruptcy could provide needed relief and might actually help you improve your credit going forward. 
• You’re nearing retirement with little saved: When consulting older clients, Morgan also weighs retirement savings. “If you are 50 years old with limited money saved for retirement, any disposable income likely should go toward saving for retirement and not paying down debt,” she says. In this case, a timely filing could halt collections and free up cash so older borrowers can redirect income to their retirement accounts. 

Alternative funding options to consider

Debt consolidation and bankruptcy aren’t your only options. You might also try:

• Credit counseling: Nonprofit credit counselors work with you and your financial situation to map a plan for paying off your debt, like a debt management plan. If you opt into a debt management plan, a credit counselor can negotiate your debts on your behalf, roll your debts into a single payment, and potentially lower your interest rates. The U.S. Trustee program lists government-approved credit counseling agencies.
• Strategic debt payments: DIY your debt with a clear payment strategy. Debt snowball is a popular method where you make minimum payments on all debts each month and put any extra cash toward the smallest debts to wipe them away first for quick wins. With the debt avalanche method, you target the highest-interest debt first to speed debt payoff and save money on interest. 
• Balance transfer credit card: Move your debt to a new credit card, preferably with a 0% introductory APR, to help you pay off debt interest-free or with a lower rate than you currently have. Some cards offer 0% APR for up to 21 months, after which your balance will be subject to the regular APR. This method works best when you're confident you can pay off the balance within the introductory period. Keep in mind that card issuers usually charge a fee of 3% to 5% of the transferred amount. 
• Creditor negotiations: Contact your creditors to negotiate a lower interest rate or a reduced balance. They aren't required to oblige, but some creditors may be willing to work with you if you have a concrete proposal, such as agreeing to automatic payments or making a lump sum payment — especially if you’re already late on payments.
• Home equity funding: Borrow against the equity in your home to potentially save on interest with a home equity loan or home equity line of credit. If you have lots of equity in your home, you could access high borrowing limits, which could be helpful if you have excessive debt to consolidate. However, both are tied to your home, which you could risk losing if you can't afford payments.