Debt Consolidation vs. Bankruptcy – Which Option is Better?

“Every possible option should be thoroughly researched, and no quick decisions should be made,” said Martin Lynch, director of education at Cambridge Credit Counseling in Agawam, Mass. “It usually takes a long time to get into debt trouble, and the process to unwind those debts should also involve patience and consideration before you commit to any option.”

Part I: What is debt consolidation and how does it work?

Part II: Comparing debt consolidation and bankruptcy

Part III: How to decide which option is better

Bankruptcy is a federal protection that helps individuals and businesses who cannot afford to repay their debts. Bankruptcy can eliminate consumer debts and may help debtors repay what they can through court-approved debt repayment plans. The law allows individuals to file for either Chapter 7 (liquidation) or Chapter 13 (repayment) bankruptcy.

Chapter 7 bankruptcy is referred to as liquidation bankruptcy because a borrower may have to sell some of their assets to pay off their debts. In Chapter 7, any of the borrower’s assets that are not exempt from sale under law may be sold by a court-appointed trustee or turned over to creditors to settle debts. Most other debts are discharged, with some exceptions (more on that in a minute).

In a Chapter 13 filing, a court approves a repayment plan that lets the borrower repay their creditors over three to five years. Any remaining amount owed on the debts will be discharged after all payments are made under the repayment plan.

Some debts, like most student loans, most tax obligations, child support, alimony and court and criminal fines are not eligible for discharge in bankruptcy.

Here’s a comparison of debt consolidation and bankruptcy.

Qualifications

What debts qualify?

Effect on credit score

How it appears on your credit report

Length of process

Cost

Tax consequences

Benefits

Risks

Life after debt consolidation or bankruptcy

Chapter 7You must complete credit counseling within the six months prior to filing for bankruptcy, as well as a post-bankruptcy debtor education course for debts to be discharged.

You must also pass a “means test” for eligibility:

Chapter 13You must complete credit counseling within the six months prior to filing for bankruptcy, as well as a post-bankruptcy debtor education course for debts to be discharged.

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Existing debts such as:

Chapter 7A bankruptcy trustee or bankruptcy court liquidates nonexempt assets sufficient to repay creditors.

Chapter 7 bankruptcy may result in discharge of the following existing debt:

Certain items do not count toward your assets, including:

Some assets are exempt under federal and state law, and exemptions vary by state. Federal bankruptcy law allows you to keep up to $15,000 of home equity and $2,400 of vehicle equity, so your home, vehicle and other assets could be protected under state or federal exemptions. But exemptions aren’t automatic — talk to a bankruptcy attorney in your area to understand what you’re at risk of losing.

Chapter 13You can file for Chapter 13 if you have less than $394,725 in unsecured debts like credit cards and personal loans and less than $1,184,200 in secured debts like a mortgage or auto loan. Filing Chapter 13 may stop home foreclosures, though you must make timely mortgage payments during the Chapter 13 plan. You can also prevent repossession of some assets by restructuring secured-debt payments within the Chapter 13 repayment plan.

Chapter 13 bankruptcy may result in discharge of the following existing debt:

A Chapter 13 bankruptcy discharge does not eliminate long-term obligations like a home mortgage. You will continue to pay the remainder of the obligation after the repayment plan ends.

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You may see your credit score drop slightly, because applying for new credit generates a hard inquiry on your credit report and can shave a few points off your score.

Your credit score might actually improve in the short term if you pay off revolving debts (like credit cards) but keep the accounts open. Closing accounts lowers your credit limit, raising your credit utilization ratio — a major factor in credit scores — and in turn lowering your credit score. Not paying off debt or adding additional debt can also impact you negatively.

Bankruptcy is considered a very negative event and will cause serious damage to a filer’s credit score for as long as it remains on the credit report.

A Chapter 7 filing stays on your credit report for 10 years, while a Chapter 13 filing should fall off your report after 7 years.

The older negative information is, the less impact it will have on your credit score.

You may see accounts included in the bankruptcy filing removed from the report before the bankruptcy is removed. Any individual account that was included in the bankruptcy will be removed 7 years from its delinquency date.

The amount your score falls will vary depending on how many accounts are part of the bankruptcy and whether they were delinquent or charged off. Your credit score prior to bankruptcy also plays a factor in this — borrowers with higher credit scores prior to filing for bankruptcy can expect to see larger drops in credit score.

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Balances on consolidated debts will decrease or be marked as paid off, and a new loan will be added to your credit report.

Chapter 7Bankruptcy will drop off your credit report 10 years from the filing date. Accounts included in the bankruptcy will be removed 7 years from their delinquency dates.

Chapter 13Bankruptcy will drop off your credit report after 7 years from the filing date. Accounts included in the bankruptcy will be removed 7 years from their delinquency dates.

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The time frame varies from several months to several years, based on the term of the debt consolidation loan.

Chapter 7The entire process may take up to six months to complete.

Chapter 13The legal process may take several months; the repayment period will last three to five years.

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You will have to pay interest on your new loan, and rates vary widely by loan type.

Some personal loans may charge fees such as:

Credit card companies may charge a fee to make a balance transfer between credit cards. A 3% balance transfer fee is common. With a balance transfer credit card, you may be able to transfer credit card debt to a card with a 0% APR on balance transfers for a limited time, but if you don’t pay off the balance during the 0% APR intro period, your debt may begin to accrue interest.

There may be fees associated with a HELOC or home equity loan such as:

Chapter 7

Chapter 13

Generally, interest is not paid on unsecured debts. Interest on secured debts are paid through the Chapter 13 plan. How bankruptcy courts determine that rate varies by state, but the Supreme Court case Till v. SCS Credit Corp. provided guidance that the rate can be calculated as the prime rate plus 1.5%.

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None.

If you are owed a tax refund, the money may be delayed or the funds may be turned over to trustee.

Discharged debt is taxable as income, so if you have debts discharged you may need to set aside funds to pay the tax when the time comes.

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Chapter 7

Chapter 13

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Chapter 7

Chapter 13

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Be prepared to make some life changes after consolidating your debts or declaring bankruptcy.

Having the bankruptcy on your credit report will weigh down your credit score for a while, but the process also gives you a fresh start.

“Filing for bankruptcy can devastate a score, but that’s not the focus of the consumer’s decision at that point — discharging debt is,” said Lynch. He adds most filers have at least some credit offers soon after filing, although they may not receive the best rates.

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A good credit score will help you qualify for a debt consolidation loan at a lower interest rate, making it less expensive overall for you to pay off your debts. The better your credit score, the more debt consolidation options you have.

Lynch recommended speaking with a credit counselor or a bankruptcy attorney to evaluate your options if the amount of unsecured debt you’re responsible for exceeds about 20% of your income. But the decision to file bankruptcy ultimately comes down to an individual’s capacity for disciplined repayment.

“The best candidates for bankruptcy are those consumers who know what the consequences will be, know what property they may stand to lose — in the case of a Chapter 7 filer — and have done their best to determine what the 3 to 5 years of repayment would be like if they were to file Chapter 13,” said Lynch.

Jeffrey Arevalo, an financial wellness expert at Greenpath Financial Wellness, recommended you consider your income, the types of debt you have and your assets in deciding if bankruptcy is right for you — and, if so, which type of bankruptcy you would need to file.

According to Arevalo, you should consider whether bankruptcy can help you with the kind of debt you’re dealing with in the first place; there are some debts, including student loans, child support, alimony and tax debts, that won’t be eligible for discharge in either a Chapter 7 or Chapter 13 filing.

The assets you own may affect whether or not you opt for bankruptcy over debt consolidation, too. You may risk losing certain assets like secondary residence properties, valuable vehicles and other assets that aren’t exempt for sale under applicable state and federal law to pay off your debts if you file Chapter 7 bankruptcy. The rules vary by state, so check first to see what you’d risk losing if you file for Chapter 7.

On the other hand, a benefit of filing for Chapter 13 bankruptcy is that it gives you an opportunity to save your home from foreclosure or a car from repossession, if that’s a risk you’re facing.

Finally, filing would depend on whether or not you are eligible for bankruptcy.

“Based on bankruptcy guidelines in your state, if you make too much or too little of income it will determine whether or not you have the ability or inability to repay your debt,” said Arevalo.

To be eligible for Chapter 13 bankruptcy you must first:

Filing for either type of bankruptcy won’t result in your student loans being discharged in most cases, according to the experts.

“Contrary to popular belief, both federal and private student loans can be discharged in bankruptcy, but the standards applied most often — the so-called ‘Brunner test’ — are difficult for many people to satisfy,” said Lynch.

To have student loans discharged, you have to file an adversary proceeding, a lawsuit filed in bankruptcy court. That’s when you have to pass what’s commonly referred to as the Brunner Test, meaning you must prove repayment would “impose undue hardship on you and your dependents.”

The following factors determine undue hardship:

The chances of any individual borrower passing the test are slim, according to John Colwell, president of the National Association of Consumer Bankruptcy Attorneys.

“You can sue and try to prove a hardship discharge in bankruptcy but the burden of proof on the debtor is very high,” Colwell said. On top of that, Colwell told MagnifyMoney, the process is an additional expense for an already cash-strapped debtor, who would have to pay a lawyer to file the lawsuit and combat an aggressive opposition from the student loan companies.

Repayment optionsStudent loans likely won’t be discharged in either type of bankruptcy. However, if you opt to file for Chapter 13 bankruptcy, the repayment plan may reduce your payment to something more manageable for your budget — or you may have no payment at all for three to five years as you pay down your debts.

Understanding your mix of assets and and passing the eligibility test doesn’t necessarily mean bankruptcy is the best option for you over debt consolidation. And owning a house or having the credit score to qualify for a balance transfer credit card or personal loan doesn’t mean you should consolidate your debt.