Debt consolidation vs. Bankruptcy: Which is right for you?

Millions of Americans have some kind of debt in personal loans, student loans or credit cards. The average individual credit card debt alone is around $7,226.

If you’re struggling to pay off large amounts of debt, debt consolidation or bankruptcy could help. Debt consolidation can make it easier to manage multiple debts or even save you money on interest, but you’ll need good credit to qualify. Bankruptcy can eliminate or restructure your debts at the expense of your credit score.

Learn more about these debt repayment strategies and which might be better for you.

Debt consolidation

Debt consolidation is the process of rolling multiple credit cards or loans into a single credit line or loan. You’ll still owe the same amount.

With fewer creditors, you won’t have to juggle multiple monthly payments. This can make it easier to manage your debts — and avoid potential late fees or missed payments that could bring down your credit score.

If you already have good credit, consolidating your debts could save you money on interest. However, this depends on your new repayment term, your total balance, any lender fees and your new interest rate.

Here’s an example:

• Say you owe $10,000 across four credit cards and that each card has a respective balance of $1,000, $2,000, $3,000 and $4,000.
• To keep things simple, imagine that each card’s variable annual percentage rate (APR) is 22.8 percent (the national average rate).
• Assuming your APRs don’t change and you don’t use your credit cards, you’ll need to pay $280 a month for five years to pay off your total credit card debt.
• By the end of this period, you’d have paid an additional $6,845 in total interest plus the original $10,000.

Now, imagine you qualify for a debt consolidation loan with a 12 percent fixed interest rate and a four-year repayment term. Your monthly payment amount would be around $263, and your total interest charges would be $2,640. That’s roughly $4,000 in savings.

You can consolidate other types of debt besides credit cards, including medical bills and high-interest personal loans. Compare different lenders — like credit unions, online lenders or banks — to determine which offers the best terms and lowest rates and fees.

Types of debt consolidation

Here are common ways to consolidate debt:

• 401(k) loan: Some 401(k) plans let you take out a 401(k) loan — up to $10,000 or 50 percent of your account balance, whichever is greater. These loans don’t require a credit check, but repayment terms can be short. You’ll also need to repay the loan in full if you change jobs.
• Balance transfer credit card: With this, you can transfer the balance from one or more credit cards to a new one—up to your new card’s credit limit. If you have good credit, you could get a card with a low or 0 percent APR introductory rate. You won’t owe interest if you pay off the balance during this introductory period. You may be charged a balance transfer fee, however.
• Debt consolidation loan: This is a type of personal loan. Some loans are secured, meaning you need collateral in exchange for funds, but most are unsecured. Each loan comes with its own repayment terms, rates and fees. You’ll typically need to pay it back in fixed monthly payments.
• Home equity line of credit (HELOC): HELOCs are secured by your property. With one, you’ll get access to a revolving line of credit you can draw from up to a certain amount — and for a set period. You’ll have to pay back the amount you use plus interest. HELOCs may come with fixed or variable rates.
• Home equity loan (HEL): A HEL is a type of secured loan you can get if you have a significant amount of home equity. Like most loans, you’ll get a lump-sum payment you can use to repay your other debts. You’ll then have to pay back what you borrowed plus interest. Failure to do so could mean losing your home.

Bankruptcy

Bankruptcy is a legal process that can bring about debt relief to those who can no longer afford to repay what they owe. It works by either eliminating your eligible debts and liquidating certain assets to pay off the debts that remain or restructuring your current debts into a new repayment plan based on your income and assets.

Declaring bankruptcy usually begins with the debtor — you — filing a petition with a bankruptcy court. You can do this alone, but it’s generally best to consult a bankruptcy attorney. An attorney can help you decide whether bankruptcy is the best option and, if so, which type is right for you. They can also represent you during the proceedings.

Once you’ve filed for bankruptcy, any creditors trying to collect on your debts must immediately cease their attempts. This generally means they can no longer threaten wage garnishment, foreclosure or repossession.

While bankruptcy can be beneficial, it’s generally considered a last-resort option for those with crippling amounts of debt. Before considering it, here are some things you should know about bankruptcy:

• It can be expensive: Bankruptcy can cost more than you think. Prepare to pay attorney fees, credit counseling fees, administrative fees and trustee fees. You may be able to waive some fees.
• It doesn’t work on all debts: Bankruptcy can discharge many types of debt, including credit cards and unsecured personal loans. However, it doesn’t usually work on unpaid child support, alimony, federal student loans, taxes or criminal fines.
• It may damage your credit: Bankruptcy can ruin your credit, making it harder to qualify for future financing — like a mortgage loan. The higher your credit score, the greater the damage. For example, if your credit score was 780, it could drop by as much as 240 points. Bankruptcy can also remain on your credit reports for seven to 10 years.
• It may only reduce your debts: In some cases, bankruptcy may reduce your debts rather than eliminate them. This means you could still owe your creditors a portion of your original debt.
• You may lose assets: Certain types of bankruptcy can cause you to lose your assets — like your car or home.

Types of bankruptcy

There are two main types of personal bankruptcy:

• Chapter 7 bankruptcy (liquidation): With this, you must sell all nonexempt assets — like a vacation home, investments or collectibles — to pay your debts. Any remaining eligible debts are discharged. You must pass a means test proving you can’t pay back your debts to qualify. A Chapter 7 is generally best for those with minimal disposable income, few assets and a significant amount of dischargeable debt.
• Chapter 13 bankruptcy (debt restructuring): A Chapter 13 bankruptcy involves setting up a new repayment plan to pay back all or some of what you owe. Once the repayment plan ends, any remaining debts will be discharged. Generally, you won’t have to sell any assets. A Chapter 13 may be best if you have steady income, several nonexempt assets and don’t pass the Chapter 7 means test.

Other types of bankruptcy include:

• Chapter 9 bankruptcy for municipalities experiencing significant financial distress.
• Chapter 11 bankruptcy for business partnerships and corporations.
• Chapter 12 bankruptcy for family fishermen and family farmers needing a repayment plan.

Debt consolidation vs. bankruptcy

Bankruptcy and debt consolidation both have their pros and cons.

The pros of debt consolidation are:

• It could help you pay down your debts faster
• It could protect your credit score
• It could potentially get you a lower interest rate
• It rolls several debts into one with a simple new monthly payment

The cons of debt consolidation are:

• Applying for a new loan could affect your credit
• It may come with additional lender fees
• It may require collateral (secured loans)
• It must be repaid in full
• Applicants must have good credit to qualify

If you're considering bankruptcy, these are the main pros:

• Chapter 7 can give you a fresh start
• Chapter 13 can restructure your payments while protecting your assets
• It stops wage garnishments and collections

The main drawbacks of bankruptcy are:

• It can severely damage your credit score
• You may lose your assets
• You may still need to pay some of your debt (Chapter 13)
• You must pass a means test to qualify
• It remains on your credit for up to 10 years

When to consider debt consolidation

Debt consolidation could be a good option if you:

• You need help with multiple monthly payments and want to simplify your payments.
• You have good credit and qualify for a lower overall interest rate.
• You have reliable income and can reasonably make your new payments.
• You qualify for a balance transfer card or loan with a reasonable interest rate and repayment term.

“Debt consolidation offers some huge benefits,” says Joseph Camberato, CEO at National Business Capital. “It lets you reorganize and clean up your debt without going through the bankruptcy process. Even if your credit has taken a hit because of high debt or late payments, consolidating is still better than bankruptcy.”

Loan calculator

Run some numbers and decide whether debt consolidation makes sense for you — and how much money you could potentially save by going this route.

Try the loan calculator

When to consider bankruptcy

Between debt consolidation and bankruptcy, consolidation is almost always the better option. Generally speaking, you should only consider bankruptcy if:

• You have a crippling amount of debt and have exhausted all other debt relief options — including loan modification, debt consolidation, debt settlement and forbearance.
• You have a lawyer who can guide you through the process.
• Your credit score has already taken a serious hit due to your inability to pay your debts.
• You qualify for a means test (Chapter 7) and get most of your debts discharged.
• You’ve weighed the risks and benefits, and it’s your best option.

“You should only consider bankruptcy if your debt is so overwhelming that you can’t realistically pay it off in the next 2 to 5 years,” says Camberato. “Life happens — medical bills, unexpected expenses, and sometimes you end up in extreme debt. If you’re in that situation, bankruptcy might be your best option.

“But if you can manage to consolidate and pay off your debts within a few years with some effort, I would definitely suggest that route,” Camberato continues. “Bankruptcy can severely damage your credit for a long time, making it tough to rebuild.”

The bottom line

If you’re struggling to pay back multiple creditors, you could use a loan or a credit card to consolidate your debts. This can make it easier to pay off your debts and reduce the stress of juggling multiple payment due dates. It might even cut down on your total interest charges over time.

If you can’t get a handle on your debts and your credit score has already taken a serious hit, bankruptcy may be worth considering. Depending on which type you choose, you could either restructure your debts into a new payment plan or discharge your eligible debts. Just remember, bankruptcy has a long-term effect on your credit — and assets — and can take years to recover from.

Weigh your options carefully and, when in doubt, consult a bankruptcy attorney for advice.