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Bankruptcy vs. debt consolidation which is the better option?

Bankruptcy Vs. Debt Consolidation

Is debt consolidation better than bankruptcy? Usually, debt consolidation is the better option over bankruptcy. While consolidating debt can take time and effort, it will almost always have a significantly more positive impact on your overall credit score and financial health than declaring bankruptcy will. 

Debt has become so commonplace for the average American consumer that it can be difficult to spot when the debt has become too much. According to news outlet CNBC, the average American has $90,460 worth of debt.1 When debt gets out of control, it can become incredibly overwhelming. If you feel bogged down by your debt or your monthly payments have become unaffordable, it is probably time to do something proactive about your debt. 

However, many Americans live paycheck to paycheck, which can make it overly challenging to pay off their debt as it is. There are many individuals who find it necessary to file for bankruptcy or pursue debt settlement to find financial relief. There are others who might be able to handle their debt through a consolidation loan or balance transfer card so as to avoid any harm to their credit scores.

If you have overwhelming debt, exploring your options more in-depth could help you determine which is the better option: debt consolidation vs. bankruptcy.

A Breakdown of Debt Consolidation vs. Bankruptcy

FactorDebt Consolidation Bankruptcy 
Eligibility Criteria Varies by lender; often requires a stable income and decent credit score. Legal criteria based on income, debt level, and financial history.
Impact on Credit Access May improve access to credit over time as debts are paid down. Restricts access to new credit for a period; severe initial impact. 
Time to CompleteCan vary; typically 2-5 years, depending on the terms of the consolidation loan. Chapter 7 takes about 3-6 months; Chapter 13 takes 3-5 years. 
Asset RetentionAssets are not directly affected. Chapter 7 may involve liquidation of assets; Chapter 13 usually allows retention of assets. 
Public RecordNot a public record. Bankruptcy is a public record. 
Future Financial Planning Easier to plan as you have a fixed repayment schedule. Can be challenging initially due to credit restrictions. 
Tax Implications No direct tax implications; interest may be tax-deductible in some cases. Discharged debts may be taxable as income. 
CostsInterest on the new loan, potential fees. Legal fees, court costs, counseling, and education course fees. 
FlexibilitySome flexibility in choosing terms and lenders. Strict legal process with little flexibility. 
Effect on Co-signers Co-signers can be included in the consolidation loan. Co-signers may still be liable for debts unless they file for bankruptcy too. 
Disclaimer: This table is intended for informational purposes only and does not constitute financial or legal advice. The specifics of debt consolidation and bankruptcy can vary based on individual circumstances and laws, which are subject to change. It is recommended to consult with a financial advisor or legal professional for advice tailored to your personal situation.

How Filing for Bankruptcy Works

Bankruptcy is a legal proceeding that is vital to the proper functioning of the American economy. Bankruptcy is designed to provide debt relief to those borrowers who owe more money than they can realistically afford to pay back. It provides a way out for borrowers with too much unsecured debt by wiping their slate clean and offering them a repayment schedule that works for their financial situation.

The bankruptcy process differs depending on the type of bankruptcy that is being filed. The two most common types of bankruptcy for individual filers are Chapter 7 Bankruptcy and Chapter 13 Bankruptcy. 

Chapter 7 Bankruptcy

Chapter 7 bankruptcy is better known as liquidation bankruptcy as it liquidates your assets to pay off your creditors. To qualify for Chapter 7 bankruptcy, you need to be making under a specified gross annual income. After the court-appointed trustee handles the liquidation of eligible assets, all your remaining debt will be discharged fully except for a few exceptions, such as student loans.

Chapter 13 Bankruptcy 

Chapter 13 bankruptcy acts a bit differently than Chapter 7 as it essentially reorganizes your debt rather than erasing it. Also known as the repayment plan chapter, chapter 13 bankruptcy sets up debt management plans for filers so that they can repay at least a portion of their unsecured debts. The single monthly payment assigned to you will depend on what you can afford according to your income. Your existing debts will be slowly paid off over a period of three to five years, and, in some cases, a portion of your unsecured debt may be discharged if it cannot be repaid within a certain amount of time. 

How Debt Consolidation Works

Debt consolidation is a debt management solution that takes several high-cost loans or credit cards and combines them into a single balance with a more affordable interest rate and one monthly payment. A debt consolidation program can be an excellent solution to make repayment easier.  

Debt Consolidation Loan

A debt consolidation loan combines all your debt balances into one convenient place so you can have a single interest rate and a single monthly payment instead of having to keep track of many. The best debt consolidation loans will also get you a lower interest rate or reduced monthly payments to make the repayment process more affordable. 

A debt consolidation loan can come in a variety of forms. Debt consolidation companies offer loans for the express purpose of debt relief for individuals who need the hands-on help provided in a debt consolidation program. Many individuals choose to use a large personal loan, which may be secured or unsecured loans, for their debt consolidation, while others turn to secured loans like a home equity loan or home equity line of credit to get even lower interest rates. However, be aware that if you use a home equity loan for debt consolidation, you are potentially putting your home at risk. 

Balance Transfer Credit Card

Another way many people choose to consolidate debt is through a balance transfer credit card. A balance transfer card can be incredibly cost-effective for credit card debt if you can qualify for a card that offers a promotional 0% APR. Some credit card companies will offer new customers an introductory promotional period of a 0% annual percentage rate for the first year to 18 months for debt consolidation.  

If you use one of these promos wisely, the balance transfer card could act as an interest-free debt consolidation loan. All that you need to do is combine your balances onto the card and pay down all of your remaining credit card debt before the end of the promotional period.

Is a Balance Transfer Card a Good Choice?

This is not the best option for borrowers who have too much debt to reasonably be paid off within a year to 18 months. If the balance can’t be paid off before the promotional period ends, you will be subject to high interest rates. But if you can aggressively pay off the balance within a year, you could save a fortune on interest costs. 

How To Determine Which Is the Better Option: Debt Consolidation vs. Bankruptcy 

Determining whether debt consolidation vs. bankruptcy is the better option depends entirely on your needs and priorities. How bankruptcy and debt consolidation affect credit differs in that one of them might be more difficult to recover from than the other. 

Bankruptcy will remain on your credit report for up to seven to ten years, while a debt consolidation loan or balance transfer card could improve your credit if you keep up with your repayment period. If you simply cannot afford to repay your debt even after consolidation, defaulting and collection accounts could be even more detrimental to your credit score than bankruptcy.

Here are some ways you might be able to tell if debt consolidation vs. bankruptcy is right for you:  

Bankruptcy Could Be the Better Option If…

Filing bankruptcy should be a last resort option for those who cannot pay their debts another way. If you cannot afford to pay creditors and need a fresh financial start, it might be time to contact a bankruptcy attorney to get their professional opinion. 

Debt Consolidation Could Be the Better Option If…

If you think you are able to afford to pay back your debt if it is reorganized and simplified, debt consolidation could be the ideal solution to protect your credit report. A debt relief agency could advise you on what options might be available to you to save money and ease your journey to a debt-free life. 

How To Rebuild Your Credit After Bankruptcy

Attempting to recover and rebuild your credit after you file bankruptcy can be an intimidating task. However, it may be less of a challenge than you think, as the most significant action it requires is patience. Time and responsible financial choices can help you attain a credit score you never thought you’d be able to reach again.  

There are a few helpful things you can do in the aftermath of bankruptcy that will build stability in your credit and overall finances. After some time, you may see your credit score increase once bankruptcy falls off your credit report. In the meantime, here are some suggestions for the first couple of years after you file bankruptcy:

Complete Credit Counseling / Use a Credit Counselor 

All those who have filed for bankruptcy are required to complete the free credit counseling course provided by the legal system. It is important to get every bit of knowledge that you can out of these credit counseling sessions. This information will help you learn how to reintegrate credit in a responsible manner so that you don’t end up in the position you were in before. 

If you have the ability and resources, you can also pursue further financial education with a nonprofit credit counseling agency to equip yourself with knowledge that will help you attain better stability. Additionally, there is an abundance of free online resources you can utilize to improve your financial literacy. 

Avoid Applying for New Credit

After a bankruptcy filing, put a pause on applying for any and all new credit. While it is true that you are unlikely to be approved for new credit directly after bankruptcy, that is not the foremost reason why you should avoid applying for new loans and credit cards. Every time you fill out an application for credit, a hard inquiry shows up on your credit profile and brings down your credit rating. 

Constantly applying and getting rejected for credit products will make it incredibly difficult to improve your credit score, which should be a priority after bankruptcy. And bad credit loans can have incredibly high interest rates. Taking a break from applying for a new loan or credit card will give your credit reports time to recover from the blow they received through the bankruptcy and discharge entries. 

Check Your Credit Report Often

Most financial experts recommend that consumers check their credit reports as often as they are able to catch any errors or inconsistencies. Every consumer has a legal right to receive a free credit report from each credit bureau annually. It is a good idea to check your credit report more often directly post-bankruptcy, so you can keep your report in the best shape possible while you recover financially. 

Checking up on your credit report will also allow you to catch exactly when various debts are discharged or how your debt payments are affecting your credit score. Monitoring the changes closely will alert you to when you might be ready to apply for new credit or make changes to your strategy. 

Use Credit-building Products

If you would like to repair your credit more quickly, you might be under the impression that you can’t actively build credit because you won’t be approved. However, there are credit-building products like secured credit cards which may allow people to get a credit card after bankruptcy. Other products, like credit-builder loans, were designed for bad credit borrowers to help improve their financial situation when paying off their loans. 

These lending products are secured with a cash security deposit which enables borrowers with a poor score to build credit by making monthly payments.

How Will My Credit Be Affected?

By getting a secured credit card or credit-builder loan, you could significantly improve your payment history, which is worth 35%, the largest portion of your credit score calculation. This could give your credit score the final boost you need to be approved for a regular credit card. 

Begin Using Credit Responsibly and Sparingly

When you are finally able to qualify for a traditional credit card or loan, it’s important to handle them responsibly so that you don’t end up with overwhelming debt again. Once you start using credit again, start slowly and keep your debt minimal. Pay off your credit card balances every month so that you keep your credit utilization rate low. This will also have the bonus of saving you money on interest charges. 

Your credit won’t be repaired overnight after something as significant as bankruptcy. But if you have patience and dedication, you are sure to see results that may surprise you. Once seven to ten years have passed, the bankruptcy will be removed from your credit report, and your credit score will improve immensely. 

FAQ: Debt Consolidation Loans, Debt Settlement vs. Bankruptcy 

What role does a debt settlement company play in debt consolidation?

A debt settlement company negotiates with creditors on your behalf to settle debts for less than what is owed. This is different from debt consolidation, where you take a new loan to pay off existing debts.

How do personal loans fit into debt consolidation?

Personal loans can be used for debt consolidation by combining multiple debts into a single loan with a potentially lower interest rate. This simplifies payments and can reduce the overall cost of debt.

Can a credit counselor help in choosing between debt consolidation and bankruptcy?

Yes, a credit counselor can provide guidance on personal finance and help assess whether a debt management plan through consolidation or filing for bankruptcy is the best course of action based on how much debt you have.

Is it possible to include medical bills in a debt consolidation plan?

Yes, medical bills can often be included in a debt consolidation plan. A new debt consolidation loan can cover various types of unsecured debts, including medical bills.

How do debt settlement companies differ from a credit union when it comes to dealing with debt?

Debt settlement companies focus on negotiating debt settlement, often for a fee. Credit unions, on the other hand, may offer their members debt consolidation loans or personal loans with favorable terms.

What should be considered before taking a new debt consolidation loan?

Before taking a new debt consolidation loan, consider the interest rate, loan terms, fees, and how the monthly payment fits into your personal finance budget. Ensure the consolidation loan actually reduces your financial burden.

How does a debt management plan compare to filing for bankruptcy?

A debt management plan, often facilitated by credit counseling agencies, involves negotiating with creditors for lower interest rates or payments. Bankruptcy, however, legally discharges or reorganizes debts but has a more significant negative impact on your credit score.

Can bankruptcy discharge all types of debts?

Bankruptcy can discharge many types of debts, but there are exceptions like certain tax debts, student loans, and alimony/child support obligations. It’s important to consult with a legal advisor for specifics.

What are the long-term effects of debt consolidation and bankruptcy on personal finance?

Debt consolidation can positively impact personal finance by simplifying debt repayment and potentially lowering interest rates. Bankruptcy can provide relief from overwhelming debt but can negatively impact credit and personal finance for several years.

How much debt is typically required for debt consolidation to be effective?

There’s no set amount, but debt consolidation is generally more effective when you have a substantial amount of debt from multiple sources. It’s best to evaluate if the consolidated payment is manageable within your budget.

CreditNinja’s Thoughts on if Debt Consolidation Better Than Bankruptcy 

When dealing with debt, CreditNinja encourages everyone to seek out consolidation options first and turn to bankruptcy only as a last resort. You may also find it helpful to get a temporary part-time job, have a garage sale and sell your old stuff, or even set a budget and tighten your spending habits when you need some extra cash to pay off your debts. You can also check out the CreditNinja dojo for more free resources on handling your finances, saving money, improving your credit score, finding the right kind of personal installment loans, and more!

References:
1. Average American Debt by Age | CNBC
2. Bankruptcy or Debt Consolidation: Which Is Better for You? | Experian
3. Debt Consolidation v. Bankruptcy: Which is Better? | Nolo
4. Debt Consolidation Vs. Bankruptcy: What Is The Difference? | Forbes Advisor

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