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If your debts are becoming unmanageable, bankruptcy and debt consolidation are two remedies to consider. While debt consolidation is significantly less damaging to your credit, it's not possible for everyone. If you're getting overwhelmed with debt, here's a rundown on which option may be better for you.
What Is Bankruptcy?
Bankruptcy is a legal process, overseen by federal courts, that's designed to protect individuals and businesses overwhelmed with debt. The two types of bankruptcy that apply to individuals are Chapter 7, also known as liquidation bankruptcy, and Chapter 13, or reorganization bankruptcy.
Both Chapter 7 and Chapter 13 bankruptcies can effectively erase, or discharge, many types of debt, including outstanding credit card balances, unpaid rent and utility bills, and private debts between you and friends or family members.
Bankruptcy cannot discharge all debts, however. Obligations excluded from discharge through bankruptcy include criminal fines, court-ordered alimony and child support payments, and unpaid taxes.
Bankruptcy also doesn't prevent mortgage lenders and auto financing companies, and other issuers of secured loans (those that use property as collateral), from foreclosing on or repossessing the property if you still owe money on it.
Chapter 7 Bankruptcy
Under Chapter 7 bankruptcy, a court-appointed trustee supervises the liquidation of your assets—with certain exceptions, including up to a certain amount of equity in your primary vehicle, work-related tools and equipment, and basic household goods and furnishings. Proceeds of the liquidation go to your creditors. With some exceptions, outstanding debt that remains is eliminated, or discharged, when your bankruptcy is finalized.
Consequences of a Chapter 7 bankruptcy are significant: You will likely lose property, and the bankruptcy will remain on your credit report for 10 years. Should you get into debt again, you cannot file again for bankruptcy under Chapter 7 for eight years after your initial filing.
Chapter 13 Bankruptcy
Chapter 13 bankruptcy lets you keep your property in exchange agreeing to a debt-repayment plan. The bankruptcy court and your attorney will negotiate a repayment plan spanning three to five years, during which you'll repay some or all of your debt. At the end of the repayment plan, if you've made all the agreed-upon payments, your outstanding debt is discharged, even if you only repaid part of what you originally owed.
If you can afford it (something you should discuss with an attorney), Chapter 13 may be a more favorable choice than Chapter 7. It allows you to retain some assets and "falls off" your credit report after seven years. While no one wants to consider the option, you can file again under Chapter 13 in as little as two years after your first case is finalized.
What Is Debt Consolidation?
Debt consolidation is a strategy that combines multiple debts into one loan or credit card with the goals of reducing both the number of payments you must keep track of each month and the amount of interest you pay.
If you're having trouble managing several credit card bills and perhaps a medical bill or a personal loan, debt consolidation lets you merge, or consolidate, them by taking out a personal loan, line of credit or a new credit card with sufficient spending limit to pay off all the loans. Doing this means you'll have one monthly payment in place of the handful you're juggling. Even better, because the interest rates on credit cards are often very high, your new monthly payment may be lower than the sum of all your old ones.
There are several forms of credit you can use to consolidate debt, including the following:
- Personal loan: If you have good credit, using a personal loan for debt consolidation is often a better option than using a new credit card. Personal loans almost always have lower interest rates than credit cards, so paying off your outstanding card balances with a loan can bring significant savings in interest payments every month. Plus you'll have a single consistent payment to manage every month, simplifying your debt payoff strategy.
- Balance transfer credit card: A balance transfer credit card with a low or 0% introductory annual percentage rate (APR) can save you on interest charges as well, but it's potentially riskier than a personal loan. Introductory APRs typically last no more than 20 months, and any portion of the transferred balance that's unpaid at the end of the introductory period will be subject to the card's standard interest rate on purchases. Certain cardholder agreements even stipulate that balance transfer balances must be paid in full by the end of the introductory period or you'll be charged interest retroactively on the full amount you transferred, not just the remaining balance. That can lead to a costly interest charge that negates much of the benefit of the debt consolidation strategy. That said, if you're sure you can pay off the transferred balance before the 0% intro period ends, you could save the most money this way, even taking balance transfer fees into account.
- Personal line of credit: If you qualify for a sufficiently large unsecured personal line of credit (offered by many credit unions and some other financial institutions), you'll likely see many of the same interest payment benefits as you do with a personal loan. Depending on the total you owe on your other loans and accounts, it may be difficult to get a personal credit line large enough to cover them all.
- Home equity line of credit: If you own a home and have paid enough of your mortgage to have significant equity in the property, using a home equity line of credit (HELOC) to consolidate your debts could reduce your interest costs as well. HELOCs typically allow you to borrow against a portion of the equity in your home for a 10-year stretch known as the draw period, during which you make interest-only payments against the balance you use. At the end of the draw period, you must begin paying principal, which can mean a major increase in monthly expenses. Note that failure to repay a HELOC according to the borrowing terms can mean the loss of your home.
How Do Bankruptcy and Debt Consolidation Affect Credit?
Bankruptcy does major damage to your credit. A Chapter 7 bankruptcy, because it stays on your credit report for 10 years, is probably the single worst negative event that can show up on your credit report. Bankruptcies adversely affect your credit scores the whole time they appear on your credit reports, and even though their score impact diminishes over time, many lenders won't even consider a credit applicant with a bankruptcy in their credit report.
Debt consolidation can have a positive or negative impact on your credit, and even both at once.
If you use a personal loan to pay off credit cards with high balances, your credit scores could improve because of a lower credit utilization ratio—the percentage of a credit card's borrowing limit represented by the outstanding balances on the card. Credit card accounts with balances that exceed about 30% of their borrowing limits can have a negative impact on your credit scores, so replacing those balances with a personal installment loan could help your scores.
On the other hand, using a balance transfer credit card to consolidate multiple credit cards and loans could create a high-utilization situation. If the total amount transferred to the new card exceeds 30% of its borrowing limit, that will likely have a negative influence on your credit score—but if the cards you're paying off through the balance transfer had high utilization, the net impact on your credit scores might be insignificant.
Like credit cards, personal lines of credit and HELOCs are forms of revolving credit that allow you to borrow against a limited amount of funds. High utilization on those accounts could also hurt your credit score.
Credit utilization is responsible for about 30% of your FICO® Score☉ , which means that high utilization can hurt your credit scores, but also that your scores will respond relatively quickly as you lower your credit utilization. If you're confident that you can pay down a revolving balance quickly, it may be worthwhile to take a temporary credit score drop in exchange for significant savings in interest payments.
Is Bankruptcy or Debt Consolidation a Better Option?
In light of the potentially devastating consequences of bankruptcy, debt consolidation is always a preferable alternative, assuming you're eligible to do it.
Debt consolidation depends on your ability to obtain new credit in the form of a loan, credit card or revolving account. If high debts are making bankruptcy a practical consideration, you may no longer be in a position to secure a new loan or card you can use to consolidate your debt.
And while a HELOC may be an option if you own a home, you won't likely qualify if, like many bankruptcy candidates, you've missed one or more payments on your primary mortgage. If you do qualify for a HELOC, take care to ensure that you can keep up with the payments, both during and after the draw period, or you'll be putting your home at risk.
Finally, even if you qualify for a debt consolidation loan but know you won't have sufficient means to pay it or your other bills, then it may be time to think about bankruptcy as your best option.
Bankruptcy, in other words, is the clear choice to make if debt consolidation and other measures such as a debt management plan aren't possible, or viable over the long term.
The strong negative effects of bankruptcy mean you should always consult with a lawyer before pursuing that option. But if you cannot use debt consolidation or other strategies to bring your debt under control bankruptcy, despite its severe consequences, may be worth it if they allow you a financial fresh start.