Debt Consolidation vs. Bankruptcy: What's the Difference?

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Finding the best way to get out of debt for your situation is rarely straightforward. Companies that advertise to help you get out of debt usually only focus on one option that may not be suitable for your situation. Here’s what you need to know about debt consolidation and bankruptcy, which are two of the major methods used to get out of debt.

What is Debt Consolidation and How Does It Work?

Debt consolidation is a relatively simple way to start the process of paying off your debt. Essentially, you apply for an unsecured loan and use the proceeds to pay off all of your other unsecured debt. The goal of debt consolidation is to lower your interest rate on the debt you owe, allowing you to pay less in interest charges and put more money toward paying down your debt. Additionally, debt consolidation may have a positive effect on your credit score.

Let's say you owe $12,000 spread out on four different credit cards—$3,000 on each—that have interest rates ranging from 14.99% to 22.99%. In order to consolidate your debt, you’d have to take out a loan for $12,000 and use it to pay off all four credit cards. If you have an excellent credit score and take out a $12,000 personal loan with a 12% interest rate, you'll save quite a bit of money that would otherwise go toward interest.

Usually, debt consolidation loans are unsecured personal loans. If you’d prefer to get a lower interest rate on your debt, you may be able to use a home equity loan, but the loan will be secured, meaning the lender can foreclose on your home if you miss a payment. Another option is using a credit card that has a promotional 0% APR on balance transfers to consolidate your debt. While it's not recommended, you can also use a 401(k) loan.

How Does Bankruptcy Work?

Bankruptcy is another way to eliminate your debt, but it's usually more complicated than debt consolidation. There are two major types of bankruptcy: Chapter 7 bankruptcy—often referred to as liquidation bankruptcy—and Chapter 13 bankruptcy—often referred to as reorganization bankruptcy. No matter which type of bankruptcy you file for, it'll have a negative effect on your credit score for seven to 10 years after filing. Both forms of bankruptcy can be complicated and may require you to hire a lawyer or bankruptcy expert to work on your behalf, which can be costly.

While many people don't qualify for Chapter 7 bankruptcy, it offers a fast way to pay off debt by erasing all debt that is legally capable of being erased. However, some types of debt, such as child support, tax debt, student loan debt and debt created through fraud, usually must be repaid. You'll have to forfeit any non-exempt property in exchange for your debts being erased.

You may not qualify for Chapter 7 bankruptcy if:

  • You earn more than the median income for your state.
  • You have previously had debt discharged through bankruptcy within the last six to eight years.
  • Your income, expenses, and debt qualify you for Chapter 13 bankruptcy.
  • You fail to attend credit counseling.
  • You have tried to defraud your creditors or the bankruptcy court.

Chapter 13 is the other major type of bankruptcy that allows you to reorganize your debt without handing over any property. In Chapter 13 bankruptcy, you’ll follow a repayment plan to repay your debts over a period of three to five years depending on your particular circumstances. When filing for Chapter 13 bankruptcy, you’ll have to repay your certain debts that have priority in full—such as taxes and child support payments—as well as making payments on secured debts such as car loans and mortgages. If you have any remaining disposable income, you’ll be required to make a good faith effort to make payments on unsecured debts.

Debt Consolidation vs Bankruptcy: Which Makes More Sense?

If you’re going to restructure your debt, choosing between debt consolidation and bankruptcy may seem like an easy choice. Bankruptcy gives you a chance to avoid repaying the debt in full, which seems like a smart move. However, the negative effects of bankruptcy should be heavily considered before moving forward with bankruptcy. You may want to give serious consideration to bankruptcy if you can’t make your minimum payments every month, or if your total unsecured debt exceeds your annual net income.

Sometimes debt consolidation makes more sense even though it may require paying back more money. Debt consolidation may be a better choice if you’re planning on making major purchases—such as an expensive new car or a home—in the next few years since bankruptcy severely damages your credit. Additionally, if your assets are over what Chapter 7 bankruptcy allows, you should consider consolidating your debt rather than filing for bankruptcy. The exemption limit varies based on state laws, but some states allow you to use a federal bankruptcy exemption list. Bigger federal exemptions include:

  • Real property, such as real estate, of up to $23,675.
  • Motor vehicle of up to $3,775.
  • Household goods of up to $600 per item and $12,625 in total.
  • Jewelry of up to $1,600.
  • Tax-exempt retirement accounts.
  • IRAs and Roth IRAs of up to $1,283,025.

Unfortunately, consolidating your debt may not always be smart or even possible. Bankruptcy should be considered if you have a large debt that you cannot reasonably pay back. If you don’t have many assets, and don’t plan on making any major purchases requiring a loan in the next few years, bankruptcy may be more suitable so long as you’re able to accept the negative impact on your credit score. If you had an excellent credit score of 780 or more prior to bankruptcy, your score may drop as much as 240 points and the bankruptcy will stay on your credit report for seven to 10 years.

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