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As a strategy for dealing with overwhelming debt, debt consolidation is always preferable to filing for bankruptcy. If debt consolidation isn't possible in your situation, bankruptcy may be a last-resort option.
What Is Bankruptcy?
Bankruptcy is a federal court procedure created to protect people and businesses saddled with crippling debt.
Bankruptcy can eliminate, or discharge, many types of debt, including unpaid credit card accounts, rent and utility bills and private debts owed to friends or family members. However, bankruptcy cannot discharge all debts. Unshielded exceptions include alimony and child support obligations, unpaid taxes and criminal fines.
Declaring bankruptcy also cannot prevent issuers of secured loans—debts that use property as collateral, such as mortgages and auto loans—from seizing and selling the collateral property to recoup what you owe them.
Two types of bankruptcy apply to individuals: Chapter 7, also known as liquidation bankruptcy, and Chapter 13, also called reorganization bankruptcy.
Chapter 7 Bankruptcy
Under Chapter 7 bankruptcy, a court-appointed trustee oversees the sale of your property and then distributes the proceeds among your creditors—the people or companies you owe money. Certain assets are exempt from this liquidation process, including your primary vehicle, work-related tools and equipment and basic household goods and furnishings. If the sale of your property cannot satisfy your debts, creditors must accept partial payment (or none at all) and the court discharges any remaining unshielded obligations.
A Chapter 7 bankruptcy has major repercussions: Aside from the loss of property, the bankruptcy will remain on your credit report—and hurt your credit scores—for 10 years. If you manage to get overwhelmed by debt again, you'll be forbidden from filing Chapter 7 bankruptcy for eight years from the date of your initial filing.
Chapter 13 Bankruptcy
A Chapter 13 bankruptcy proceeding establishes a debt repayment plan that lets you keep more of your property. The court and your attorney work out a three- to five-year repayment plan, during which you'll make payments toward your debt. If you stick to the payment schedule, even if doing so doesn't cover all that you owe, your outstanding debt will be discharged at the end of the repayment period.
If you can afford it (an attorney can help you determine whether you can), Chapter 13 is often a more favorable choice than Chapter 7. It allows you to retain some assets and expires from your credit report after seven years instead of 10. While it's not advisable, you can file Chapter 13 bankruptcy as little as two years after your first case is finalized.
What Is Debt Consolidation?
Debt consolidation is the combining of multiple high-cost loans or credit card accounts into a single debt with a more affordable interest rate.
Imagine you have three credit cards with borrowing limits of $6,000 each, respective balances of $2,000, $5,000 and $3,000, and variable annual percentage rates (APRs). For simplicity's sake, let's assume that the APR on each card is the current national average of 17.5%.
If APRs don't increase and you don't make any additional charges on the cards, paying them off in four years' time would require average total monthly payments of about $291. That would mean paying about $3,975 in interest on top of the $10,000 combined balance.
In contrast, if you use a 48-month $10,000 personal loan to pay off the accounts, at a fixed rate of 7%, your monthly payment after a 7% origination fee would be about $253, and your total loan cost (including the $700 fee) would be $2,874, or about $1,100 less than you'd have paid in credit card interest.
Aside from saving you money, this approach has several other advantages:
- Personal loans typically have fixed interest rates, while most credit cards have variable rates that rise with market rates, adding to the cost of paying off existing card balances.
- The payment on a personal loan is the same each month, while required payments on credit card accounts typically change month to month, making them unpredictable and a potential budgeting challenge.
- Balances that exceed about 30% of a card's borrowing limit (a measure called credit utilization) can bring down your credit scores. In our example, utilization for the cards was 33%, 83% and 50%, respectively, so using a loan to pay them off (and reset their utilization to 0%) would benefit your credit score.
Debt consolidation doesn't just apply to credit card debt, of course. You can use it to roll up medical bills, loans from friends or relatives and other obligations into a single, manageable monthly bill.
How to Consolidate Debt
There are several forms of credit you can use to consolidate debt, including the following:
- Personal loan: If you qualify for one, using a personal loan for debt consolidation is often the best option. 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 and one consistent payment to manage in place of multiple card bills of varying amounts.
- Personal line of credit (PLOC): If you qualify for a sufficiently large unsecured personal line of credit (available from many credit unions and some banks), you'll likely get many of the same interest-cost advantages of a personal loan. PLOCs work like credit cards during their draw period: You make and repay charges at will, using the credit line amount as a borrowing limit and paying interest only on the amounts you use. After the draw period, you must repay your balance in equal installments over a repayment period of up to 10 years.
- Balance transfer credit card: A balance transfer credit card with a low or 0% introductory APR can help you avoid interest charges, but you'll likely have to pay balance transfer fees and it's a bit riskier than a personal loan. Introductory APRs typically last no more than 21 months, and any part of the transferred balance you haven't paid off by the end of that time will be subject to the card's standard interest rate for purchases. With some cards, failure to pay off the full transferred balance by the end of the introductory period means you incur interest on the full transferred amount, not just the remaining balance.
- Home equity loan or home equity line of credit (HELOC): If you own a house and have significant equity in it, a home equity loan or home equity line of credit could help consolidate your debts and reduce your interest costs as well.
Because they're forms of second mortgages, failure to make payments on a home equity loan or HELOC can cost you your home.
- A home equity loan provides a lump sum at a relatively low fixed interest rate, which you can use to pay off more costly debt such as credit card balances.
- A HELOC allows you to make charges and repayments like a credit card, using a portion of your home equity as the borrowing limit. You can make charges and relatively low interest-only payments for the draw period, during which you make interest-only payments against the balance you use. At the end of the draw period, the HELOC repayment period begins and you can no longer make new charges and must begin repaying the principal on your outstanding balance. Most HELOCs come with variable interest rates, like credit cards.
How Do Bankruptcy and Debt Consolidation Affect Credit?
Bankruptcy severely hurts your credit. Bankruptcies adversely affect your credit scores the whole time they appear on your credit reports.
It may seem paradoxical, but the number of points your credit scores drop after a bankruptcy filing may not be that great, because bankruptcy is typically preceded by other events that knock down credit scores significantly, such as:
A bankruptcy will keep your scores down, however, especially in the first few years after you file. While the credit score impact of a bankruptcy lessens over time, even if you build back your credit, many lenders will refuse to work with you until the bankruptcy expires from your credit report.
Debt consolidation can have a positive or negative impact on your credit, and even both at once. The reason is credit utilization, which is responsible for about 30% of your FICO® Score☉ , the score used by 90% of top lenders. As discussed above, using a loan to pay off high-balance credit cards helps credit scores by reducing credit utilization (since utilization applies to revolving credit, like credit cards, and not installment credit, like a personal loan). On the other hand, using a balance transfer credit card to consolidate multiple credit cards can save you money but create a high-utilization situation on the new card.
Like credit cards, personal lines of credit and HELOCs are forms of revolving credit that allow you to make charges against a borrowing limit. High utilization on those accounts could also hurt your credit score (though some scoring models don't include HELOCs in score calculations).
Credit scores can respond relatively quickly as you lower your credit utilization, so if you're confident you can pay down a revolving balance quickly, it may be worthwhile to take a temporary credit score drop to gain significant savings in interest charges.
Is Bankruptcy or Debt Consolidation a Better Option?
Given the choice, debt consolidation is always a better option than bankruptcy. Debt consolidation is only possible if you can qualify for a new loan or credit card account you then use to pay off your higher-cost debts. If that's not an option, bankruptcy may be your best resort.
The Bottom Line
If your debts are piling up and you're starting to feel overwhelmed, a debt consolidation strategy can help ease the pressure and save you money over the long haul. If your circumstances make it impossible to get new credit, using the bankruptcy process to get a clean slate on debt is a painful choice, but one you can eventually recover from and move forward.
Whether you're contemplating a debt consolidation loan or working to rebuild your credit to stave off bankruptcy (or recover from it), keeping track of your FICO® Score from Experian can help you know where you stand.