When you are having trouble managing debt, two common solution options are bankruptcy and debt consolidation. Debt consolidation and bankruptcy are distinct financial strategies to manage debt. Each has its own effects on your credit, assets, and long-term financial health.

Whether debt consolidation or bankruptcy is best for you depends on your financial circumstances and your preferences. 

If you want to find out if debt consolidation or bankruptcy is best for your unique financial situation, please call Stone Rose Law at (480) 739-2448.

What is Debt Consolidation?

Debt consolidation involves combining multiple debts into a single loan or payment plan, often with a lower interest rate, to simplify repayment and potentially reduce overall interest costs.

Types of Debt Consolidation

You have several options for consolidating debt. Here are some of the more common ways.

Common Debt Consolidation Methods

Balance Transfer Credit Card

A balance transfer credit card offers a low or 0% introductory annual percentage rate for balance transfers, usually from other credit card debts. You may need to pay a balance transfer fee, usually 3% to 5% of the balance you transfer to the card.

Your introductory rate can last for a year or more. During this interval, you can save on the interest you would otherwise be paying on your transferred debt, which can help you make better headway against the principal you owe.

A balance transfer credit card can be a good choice if you can pay off your debt within the introductory interest rate period. When the introductory period is over, the card’s regular interest rate will apply.

Debt Consolidation Loan

A debt consolidation loan is a personal loan. It usually offers a lower interest rate than credit cards and has structured payments over a fixed term of one to seven years.

A debt consolidation loan can be a good choice if you have good credit. The better your credit score, the more likely it is that you will qualify for a lower interest rate. 

Like with many balance transfer credit cards, debt consolidation loans will often charge a fee to transfer debt. However, instead of a balance transfer fee, this is called an origination fee and it is typically taken from your loan disbursement.

A debt consolidation loan can be a good choice if you have a good or excellent credit rating and an income sufficiently stable to pay off a fixed-term loan over a period of years.

Home Equity Loan

If you have a house with enough equity, a home equity loan is an option to use some of that equity to pay off high-interest debts. A home equity loan is basically a second mortgage on your home, and your home is the collateral. If you fail to keep up with payments, you could risk losing your home.

To qualify for a home equity loan, typical lender requirements often include a credit score of 620 or better and a loan-to-value ratio of less than 80%. These loans have repayment terms between five and 30 years, with closing costs ranging from 2% to 5% of the loan amount.

If you sell your home before paying off your home equity loan, then your loan payoff will come from the proceeds from the home sale.

Home Equity Line of Credit

A home equity line of credit is like a home equity loan in that you can tap your home’s equity to consolidate high-interest debt. Instead of receiving a lump sum loan, though, you will ordinarily receive a credit limit you can draw on for a certain period. A draw period of up to 10 years, during which you can borrow up to your credit limit and repay it as needed. When your draw period ends, you will be subject to a repayment period of up to 20 years to pay off your balance.

Unlike home equity loans, a home equity line of credit often has a variable interest rate rather than a fixed one. In addition to loan closing costs, this line of credit may also have an annual fee, inactivity fees, and a prepayment penalty.

A Debt Settlement Loan

If you are already falling behind in making your debt payments, creditors may be willing to consider a debt settlement for part of what you owe. This usually means you must obtain a debt settlement loan to pay reduced amounts to creditors.

You offer to pay your creditors a percentage of your loan balance from the debt settlement loan, in a lump sum or a shortened repayment period.

The main potential advantage of a debt settlement loan is that it can pay off debts for a fraction of their original amount and get you out from under those debts relatively quickly.

Some potential downsides of using a debt settlement loan are:

  • Your creditors have no obligation to accept a debt settlement offer from you.
  • If a creditor accepts a debt settlement from you, then the amount it writes off from the original loan gets reported to the U.S. Internal Revenue Service. You will receive a Form 1099 from the creditor stating the write-off amount, which will effectively count as income on your taxes and could result in you owing more taxes.
  • Loan write-offs often get reported to credit bureaus and will show up on your credit reports.

Working With a Debt Consolidation Company

A debt consolidation company works in a way similar to a debt settlement loan. These companies will negotiate on your behalf with your creditors to try to persuade them to accept a lower repayment amount and a lower monthly payment. You will make a single payment to the debt consolidation company, from which it will make disbursements to your creditors.

Caution is advisable in using a debt consolidation company, for reasons including but not limited to:

  • Like with a debt settlement loan, creditors have no obligation to work with the consolidation company.
  • Even if a creditor agrees to work with a debt consolidation company, the creditor can continue to report past-due payments and other adverse information to credit bureaus, and this can harm your credit.
  • Even if it agrees to work with a debt consolidation company, a creditor is not barred from later suing you to collect the debt or to take other legal actions against you on the debt.
  • Debt consolidation companies usually charge a fee for their services, which is included in your monthly payment.

Is Debt Consolidation a Good Idea?

Debt consolidation can be a good debt relief alternative to bankruptcy if you fit into certain circumstances, including:

  • You have a steady source of income and can afford to make loan payments.
  • You have a good credit score, so you can qualify for a lower interest rate.
  • You do not want to experience the damage to your credit score that a bankruptcy can entail.
  • You have multiple high-interest loans, like credit cards, and want to make a single payment instead.

As long as you have not already started to get into trouble with creditors through late or missed payments, a debt consolidation loan can be an effective way to make your debt payments more manageable while lowering the amount of interest you have to pay.

But if you wait to consider debt consolidation until after you start falling behind in your existing loan payments, it can be more difficult to qualify for a debt consolidation loan with a favorable interest rate.

How Does Debt Consolidation Compare to Bankruptcy?

Compared to debt consolidation, bankruptcy is a legal process that can discharge or restructure eligible debts, and its automatic stay prevents your creditors from suing you on the debt or otherwise engaging in collection efforts against you during your bankruptcy case. After discharge, creditors are barred from collection by the discharge injunction.

Bankruptcy can discharge many unsecured debts and may eliminate personal liability on secured debts if collateral is surrendered.

The two most common types of bankruptcy for individuals are Chapter 7 and Chapter 13.

Chapter 7 Bankruptcy

Chapter 7 bankruptcy discharges many kinds of debts in a short period of time, usually three or four months. It is often called “liquidation bankruptcy” because the bankruptcy trustee may be able to sell some of your property and assets that you cannot exempt under federal or Arizona bankruptcy law.

Chapter 7 is an option best suited if you are having trouble paying even part of your debts. It is also a sound choice if you have little or no income, or your income is not steady. To qualify for Chapter 7, you must pass a means test. If you do not pass this test, then Chapter 13 bankruptcy may be another option for you.

Chapter 7 typically remains on credit reports longer than Chapter 13, though the actual impact on credit scores is short term.

Chapter 13 Bankruptcy

Chapter 13 bankruptcy is also known as “reorganization bankruptcy.” Instead of eliminating debts by discharging them as in Chapter 7, the central feature of Chapter 13 is its debt-repayment plan.

Under this plan, which can last from three to five years, you will work with the bankruptcy trustee and your creditors to pay off all or some of your debts through the payment plan. If you complete your repayment plan, then the remaining balances will be discharged-it other word, eliminated.

A key advantage of Chapter 13 bankruptcy compared to Chapter 7 is that it is easier to keep your property and assets in a Chapter 13.

Another benefit of the Chapter 13 payment plan is that the interest stops accruing and you are paying a set amount. You’re also protected from lawsuits, garnishments, and levies. Your creditors are required to follow the plan that is set. 

The main potential downsides of a Chapter 13 are that it takes years to complete compared to a few months for a Chapter 7, and that while the repayment plan is in effect, it may leave you with little left in disposable income in your monthly budget.

When to Consider Bankruptcy

Debt consolidation can be advantageous in certain situations, but it is not suitable for all circumstances. Here are some factors to take into account that can make bankruptcy a more attractive option:

  • You are under crushing debt, like major medical bills, and your income is insufficient for you to catch up on late or missed payments or to stay up with current payments.
  • Your debt situation is already negatively affecting your credit score.
  • You can qualify under the Chapter 7 means test and can get most of your debts discharged.
  • You want to preserve your protected assets like your retirement accounts and home equity. Creditors cannot touch these and rather than “cashing out” these assets, you can preserve and eliminate or reorganize your debts.
  • You are only living on Social Security Income or VA disability which are protected from being garnished by creditors.

It is always a sound idea to carefully consider debt relief options short of bankruptcy if they are practically available. An experienced bankruptcy lawyer can help you to thoroughly assess your income, debts, and options so you can decide if bankruptcy is your best choice.

To get an idea of how your debt payoff can work in bankruptcy and non-bankruptcy, see our Debt Calculator Page.

Summing Up: Which is Best for You, Debt Consolidation or Bankruptcy?

The following table captures the main pros and cons of debt consolidation versus bankruptcy:

Debt Consolidation Bankruptcy
Best use cases You have a good or excellent credit scoreYou have a stable income and can manage debt payoff in monthly paymentsYou want to avoid the effects that bankruptcy will have on your credit score You are already behind on your debtsYour income is insufficient to pay your debts or too unstable to make monthly payments consistentlyYou want a fresh start by discharging some or all of your debts
Nature of procedure Private course of action. The creditors are setting the terms.  Formal legal process under US Bankruptcy Code and Arizona law. Creditors must comply with this legal process.
How to get started Need to qualify to apply for a loan or a balance transfer credit card; orUse the equity in your home; orWork with a debt consolidation company File a Petition with a United States Bankruptcy CourtMay need to pass a means test to use Chapter 7
How it works Pay off high-interest loans with a debt consolidation loan; orNegotiate with creditors to possibly reduce what you owe and your interest rate Identify your debts and assets to consider in discharging certain debts, possibly selling non-exempt assets, or entering into a debt repayment plan
Fees involved You may incur balance transfer fees, loan origination fees, or fees for using a debt consolidation company You will usually need to pay bankruptcy court fees, costs, and possibly legal fees
Credit impact Your credit score can be affected positively (reduced credit usage) or negatively (too many accounts, too many new accounts, hard credit checks) Bankruptcy will negatively impact your credit score in the short term, but you can rebuild your credit rating over a short timeBankruptcy will stay on your credit record for 7 years (Chapter 13) or 10 years (Chapter 7)
Effect on debt principal Consolidation loans do not affect how much you oweDebt settlement may reduce some of your outstanding principal balance Debts can be eliminated or reduced through discharge

Stone Rose Law Can Help You Make the Best Debt Relief Decision for You

In a free consultation, an experienced Stone Rose bankruptcy lawyer can guide you through all the viable options you have to get out from underneath heavy debt. We can familiarize you with debt consolidation options or help you decide whether a Chapter 7 or Chapter 13 bankruptcy is a more practical option.

Call us at (480) 739-2448 to speak with one of our debt-relief and bankruptcy attorneys and schedule a consultation. Or use our online contact form.

The post Debt Consolidation vs Bankruptcy: Which is Better? appeared first on Stone Rose Law.