You are in over your head in debt. Your first thought is to file bankruptcy. While it’s a viable option, you may want to consider debt consolidation too. Understanding the differences and how they affect you can help you decide. Each option has its pros and cons. No two people will have the same circumstance or decision. We’ll discuss both sides of each option below.
What is Bankruptcy?
You can file for two different types of bankruptcy – Chapter 7 or Chapter 13. When you file for Chapter 7, you eliminate your debts. This could include some or all of your debts. When you file Chapter 13, you restructure your debts. In other words, you don’t eliminate them. Instead, you make one payment to your trustee. They then disburse the funds to your creditors. This occurs over a period of 3 to 5 years.
Chapter 7 Basics
In a Chapter 7 bankruptcy, you may write off all or a portion of your debts. In order to qualify, you must meet the following:
- Pass the Chapter 7 means test. Passing means you don’t make enough money to satisfy your debts. If you make too much, Chapter 13 might be your only option.
- Certain debts can’t be discharged. Alimony, child support, student loans, and some income tax debt don’t count. Any debts for luxurious purchases within the recent past don’t count. You also can’t include any court judgements due to criminal acts.
- You may have to give up certain belongings that are non-essential.You won’t have to give up your home or cars. But, you may have to give up collections, assets, and additional property.
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Chapter 13 Basics
In a Chapter 13 bankruptcy, you keep all of your property. However, you repay all or most of your debts. In order to qualify, you must prove you have enough income to afford the restructured payment plan. You must also meet the following:
- You must attend credit counseling prior to filing.
- You must pay certain debts in their entirety. This includes taxes, child support, alimony, and any money you owe to employees.
- If you can’t complete the plan, you may have to convert to a Chapter 7.
Benefits of Filing for BK
There are some instances when filing for BK suits you better. The largest advantage is the protection you receive from creditors. Once you file for BK, the creditors cannot call you anymore. It’s called an automatic stay. Creditors cannot pursue collections against you or even harass you by phone or mail.
Filing for bankruptcy can be considered a fresh start. If you file for Chapter 7, you can discharge all or most of your debts. This leaves you with a blank slate. You may have to rent a home for a while and you may not get credit right away, but it gives you time to save money. After a few months, you can try getting a secured credit card. After a few years, you can try applying for a mortgage. If you take things slow, you can stay out of debt and live within your means.
If you file for Chapter 13, you repay your debts. You don’t lose any of your property, though. Some trustees are able to get you a lower payment for your car. You also get to keep your home. You don’t have to rent for a few years. Your credit suffers, but about as much as it does with a Chapter 7.
Disadvantages of Filing for BK
The largest disadvantage of a BK is the credit damage. Oftentimes it stays on your credit report for at least 7 years. Looking at the big picture, though, you probably already damaged your credit. Filing for BK may give you some relief. You get to start over and bring your credit score back up.
Perhaps the largest disadvantage of a BK is the lack of privacy. Bankruptcy notices are available to the public. This could mean your employer or insurance many will know about it if they pull your credit. If you file a Chapter 13, you may also have automatic wage deductions. This notifies your employer of your situation.
Last, you may lose some of your belongings. It depends on the type you file, but both options put your belongings at risk. Anything luxurious or non-essential may require sacrificing. This isn’t the case for everyone, though. Your credit counselor can help you determine where you stand.
What is Debt Consolidation?
Debt consolidation works differently than bankruptcy. With debt consolidation, you repay your debts. In order to do so, you take out a new loan. This loan pays off the old debts. The goal is to have one loan with a lower average interest rate. It should have a lower payment as well. In many cases, debt consolidation helps you avoid severe credit score damage. Of course, this assumes you make your payments on time. It also assumes that you don’t rack up your credit cards again after paying them off.
Debt Consolidation Basics
You have several options for debt consolidation. The type of debt and your financial situation determine the right choice for you. Your options include:
- Balance transfer credit card
- Personal loan
- Home equity loan
- 3rd party debt consolidation
For example, if you have multiple credit card balances, you might benefit from a balance transfer credit card. If you can find a card offering a 0% APR, you may save more money. If you have other types of debt, a personal loan or home equity loan might be a better option. This gives you funds to disburse as you see fit. You then have one payment to make each month.
The Benefits of Debt Consolidation
Debt consolidation is often less detrimental to your financial and personal life than bankruptcy. For starters, it’s not a matter of public record. Even an employer that pulls your credit won’t know the difference. All they see is your credit score. They don’t care if you consolidated debt or not.
Debt consolidation may be a little nicer to your credit score too. Because you don’t discharge the debts, your credit score doesn’t suffer as much. As long as you make your payments on time and don’t rack up more debt, your score won’t be hit as hard.
Debt consolidation often costs less too. Depending on the method you choose, you should have a lower interest rate and/or payment. If you are lucky enough to get a 0% APR credit card, you can avoid paying interest altogether. Of course, this means you must pay your balance in full before the interest starts, though.
Last, organizing your debts into one payment can make it easier to stay organized. Making multiple payments on multiple days can get confusing. Bringing it down to just one payment can help you stay on track. This may mean fewer late payments and less damage to your credit score.
The Downside of Debt Consolidation
Debt consolidation has a few downsides as well. Just as we said it doesn’t hurt your credit score as much as a BK, it can still hurt it. If you don’t make your payments on time, your credit score drops. Even worse, if you took out a secured loan, you could lose the property you used as collateral. This could mean your home, car, or 401K loan, as a few examples. The bank takes the collateral used for the loan after you miss a certain number of payments and don’t make arrangements to get current again.
Sometimes debt consolidation costs more than you realize. For example, a balance transfer credit card likely has a balance transfer fee. There might also be an annual fee and late fees. Personal loans and home equity loans often have origination fees and closing costs. Some even have prepayment penalties, which occur if you pay the loan off before the term is up.
Extending the length of your debt may also cost you more in interest. For example, if you wrap your credit card debt into a home equity loan, you just committed to 20-30 years of payments. That means 20-30 years of interest. Looking at the big picture, this debt may cost you hundreds or even thousands of dollars more than its principal balance.
Making the Right Choice
So how do you decide which option is right for you? Look at the big picture. Figure out which option suits your financial situation the best. Look at things like:
- Do you have the income to repay debts if they are restructured?
- Can you afford your current mortgage/car payments?
- Do you have assets your creditors can take for repayment?
- Do you need a fresh start?
- Will you qualify for a debt consolidation loan?
Consider these questions as they pertain to your personal situation. For example, if you don’t qualify for a debt consolidation loan, bankruptcy may be your only option. Balance transfer credit cards, personal loans, and home equity loans often require decent credit and plenty of income. In some cases, you may be able to secure debt consolidation with a credit counselor through a 3rd party non-profit agency. This freezes your credit though and can affect you for the next 3-6 years.
Making the choice between bankruptcy and debt consolidation is a personal choice. Evaluate your situation and see which option suits you the best. Either way, your credit score will decrease. However, you can work to get it back up once you get back on your feet. Both options allow you to start back up again.