Bankruptcy is a legal process that provides relief for individuals overwhelmed by debt. A bankruptcy court can release you from having to repay many debts and forbid your creditors from trying to collect them. Bankruptcy can mean a fresh start if you're over your head in debt, but it also does deep, lasting harm to your credit history.
Because bankruptcy can make it difficult to borrow money or obtain traditional credit cards for as long as 10 years from the date you seek protection from the court, it's best viewed as a last resort. Before you pursue bankruptcy, it's worth considering the following alternatives. All have potential negative consequences for your credit, but they may be less severe than bankruptcy.
1. Credit Counseling
As soon as you feel your debts starting to spiral out of control, consider seeking help from a certified nonprofit credit counseling agency. With services available nationwide, these organizations can review your household cash flow (income, debts and other expenses) and help you devise a budget and a plan for getting back on solid footing. Depending on the severity of your situation, advice and coaching from a seasoned financial counselor may be all you need to take control of your debts and stave off the prospect of bankruptcy.
If your circumstances require more than some prudent planning, credit counselors may still be able to help you head off bankruptcy by helping work out a program with your creditors that lowers your payments and can resolve your debt problems within a few years, via a debt management plan (more on that below).
2. Debt Consolidation
If you foresee difficulty paying your debts but haven't yet missed any payments—and your credit standing is at least fair to good—you may be able to avoid bankruptcy using debt consolidation. With this process, you move the balances of high-interest credit cards to a loan with a fixed monthly payment.
Taking out a personal loan or borrowing against your home equity and using the proceeds to pay down credit card balances and other high-interest debt can lower your interest costs and provide a single, predictable monthly payment in place of multiple payments.
If you prefer not to apply for a loan, you may be able to qualify for a balance transfer credit card with a 0% introductory interest rate (up to 21 months with some cards, if you have good to excellent credit). Transferring balances from other cards to the new one typically comes with a fee of 3% or 5% of the transferred sum, but it can provide temporary relief from the double-whammy of compounding interest charges and rising interest rates.
Debt consolidation has few downsides for your credit scores, as long as you avoid running up new balances on the accounts you pay off using a loan or balance transfer card. A debt consolidation loan could actually help your scores, by lowering utilization on your credit card accounts and adding to your credit mix.
3. Debt Management Plan
A debt management plan (DMP) is a repayment program a certified credit counselor can organize for you. After reviewing your finances and working with you to determine a realistic amount you can afford to put toward debt repayment each month, the counselor negotiates with your creditors with the goal of resolving your debts within three to five years. Certain types of debt, such as federal student loans and unpaid alimony or child support, cannot be negotiated as part of a DMP.
When arranging a DMP, the credit counseling agency typically tells your creditors you're facing bankruptcy, and that it's better for them to accept repayment over time through a DMP (and potentially lose out on fees and additional interest) than to force you into bankruptcy and risk collecting nothing. While many creditors will accept this argument, especially knowing you have the guidance of a credit counselor, there's no guarantee your creditors will agree. They are under no legal obligation to enter into a DMP.
While typically less damaging than bankruptcy, DMPs still have the potential to harm your credit. Credit card issuers who agree to participate in DMPs typically require accounts included in the plan to be closed. Aside from reducing your options for financing purchases, that also lowers your total amount of available credit. If you have an outstanding balance on even just one credit card not included in your DMP, closing your other accounts will decrease your overall credit limit. This can cause your credit utilization to spike and hurt your credit scores.
Typically there is a one-time fee to set up your debt management plan and an ongoing monthly fee while the plan is in place. If you cannot keep up with your repayment schedule under a DMP, you still could end up with no choice but to file for bankruptcy.
4. Debt Settlement or Debt Relief
This alternative to filing bankruptcy may not be the best one for most individuals. Debt settlement companies (which often market themselves as debt relief providers) are for-profit companies that claim they can lower your debt burden dramatically by negotiating with creditors on your behalf.
With the goal of gaining leverage over your creditors, these companies typically tell you to stop making your monthly debt payments and instead to make regular deposits in a special savings account they set up for you. When sufficient funds are accumulated in the account, they say, they'll use them to offer your creditors partial repayment, arguing that your creditors are better off taking pennies on the dollar than losing all you owe if you're forced into bankruptcy.
While this may sound similar to the DMP services credit counselors provide, there are crucial differences that make these companies a less favorable choice for most consumers:
- Higher fees: Debt settlement companies charge far higher fees than credit counselors—typically 15% to 25% of the amount of debt they settle, plus potential "maintenance fees" on the savings accounts they require you to set up. Repaying those fees can add months to your payment plan.
- Credit score harm: Ceasing all debt payments while you build up the settlement savings account will do major harm to your credit scores. The primary damage is from missed payments, but after about four months without payments, your creditors may write off your debts, close your accounts and/or sell your debt off to collection agencies—all negative events that will stay on your credit reports for seven years may impact your credit scores as long as they appear.
- Could leave you high and dry: As with a DMP, creditors are under no obligation to negotiate with debt settlement companies. But by the time you find out a creditor won't go along with a settlement plan, your credit may have seen months of damage from non-payments—and bankruptcy might still be on the table.
What Are the Potential Consequences of Bankruptcy?
Individuals can pursue one of two bankruptcy procedures under federal law, each with different credit consequences:
- Chapter 7 bankruptcy: Also known as liquidation bankruptcy, Chapter 7 bankruptcy erases most debts altogether but requires you to forfeit all but a few protected assets, such as your home or primary means of transportation. A Chapter 7 bankruptcy remains on your credit reports for 10 years from the date you petition the court for protection.
- Chapter 13 bankruptcy: This type of bankruptcy establishes a plan for partial repayment of your debts over a period of three to five years and allows you to keep certain assets. A Chapter 13 bankruptcy stays on your credit report for seven years from the filing date.
A bankruptcy may be the most severe negative entry that can appear on your credit reports. It may not cause a huge numerical score drop on its own because missed payments, loan defaults and other events that typically precede bankruptcy are likely to have already reduced your score significantly. Bankruptcy has a negative effect on your credit scores as long as it remains on your credit reports (although its severity tapers off over time).
The Bottom Line
If your debts are feeling unmanageable and you're considering bankruptcy, it's wise to consult a bankruptcy attorney and consider alternatives with less potential to damage your credit.
Whether you find a preferable option or end up resorting to bankruptcy, your credit may get worse before it gets better, but it's important to keep in mind that you're empowered to improve your situation. As you work toward building (or rebuilding) your credit, tracking your free credit score from Experian can help you chart your progress.