Bankruptcy vs. Debt Consolidation: Which Is the Better Option?
If you have debt, is it better to do debt consolidation or bankruptcy?
Contributing Writer at Tally
April 8, 2021
The total household debt in the United States is at the highest it’s ever been. As of Q4 2020, the overall debt in the U.S. was $14.15 trillion. Americans added $193 billion in debt in the fourth quarter of 2020 alone. Perhaps more concerning, the rise in serious delinquencies is rising for credit cards and auto loans. Delinquent debt is any debt that's past due.
If you have serious debt, you are likely looking for ways to get out from under it. Two options at your disposal are declaring bankruptcy and debt consolidation.
So, what is better: bankruptcy or debt consolidation? The answer depends on many different factors, including your financial situation and the type of debt you're carrying. In this article, we'll cover everything you need to know about debt consolidation vs. bankruptcy so that you can determine which is the better option for you.
Bankruptcy — what you need to know
When you file bankruptcy, you engage in a legal process of declaring your debts in federal court. Both businesses and individuals are permitted to file bankruptcy. Two types of bankruptcy apply to individuals: Chapter 7 bankruptcy and Chapter 13 bankruptcy.
If you file Chapter 7 bankruptcy, your liquid assets are used to pay off your debts. Examples of liquid assets include money that you have in your checking and savings accounts. The bankruptcy court will decide if your liquid assets are exempt or non-exempt. If they’re exempt, they aren’t subject to seizure to pay your debts. If they’re non-exempt, the courts will mandate that you use the assets to pay your debts.
The non-exempt liquid assets are turned over to the courts and distributed to lenders as partial repayment for the debts you owe. You are able to keep your assets that were exempt.
The courts will also sort your debts into those that are dischargeable and non-dischargeable. A dischargeable debt is one in which you are not responsible to pay under court order. A non-dischargeable debt, on the other hand, is one that you must pay.
After lenders receive your assets, the court waives the remaining dischargeable debts. You are no longer liable for them. Debt collectors can no longer chase you to repay the discharged debts.
The other type of bankruptcy is Chapter 13 bankruptcy. If you file Chapter 13 bankruptcy, you establish a repayment plan. Under this payment plan, you'll end up repaying all or part of your debt in a three- to five-year period. Once you submit your plan (even if it's not yet approved by the court), you’ll start making payments to a trustee, who then pays the creditors you owe.
If the bankruptcy court approves your plan, you will continue to make payments. After you have completed your repayment plan, you are no longer liable for any outstanding debts.
The pros of declaring bankruptcy
There are a couple of advantages to filing bankruptcy that you may want to consider.
The court issues an automatic stay against creditors
Perhaps the biggest advantage of filing bankruptcy is that the court issues a stay against creditors. Though your debt is not actually canceled, it suspends debt collection activity until your bankruptcy case is complete or the stay is lifted. You will not need to worry about harassing calls from creditors, lawsuits, or wage garnishments.
You may discharge debts without fully repaying them
In both Chapter 7 and Chapter 13 bankruptcy filings, you may not need to repay the entire balance of the debts you owe. For instance, if your liquid assets do not cover how much you owe in credit card debt, medical bills, personal loans, and student loans, the court may wipe away your requirement to repay these funds. Filing bankruptcy can provide debt relief and a fresh start.
The cons of declaring bankruptcy
There are a few downsides to consider when determining whether to declare bankruptcy.
There are additional costs
When filing in court, you'll need to hire a bankruptcy attorney. Though costs can vary, you should expect to spend a couple thousand dollars on an attorney. There are also costs associated with filing paperwork, including a one-time filing fee. You may not be in the financial position to take on these additional costs.
Not all types of debt are dischargeable
Though credit card debt qualifies for bankruptcy, there are other types not eligible to be discharged. These include:
Court-ordered child support
Additionally, your secured debts are still eligible for repossession. If you have a mortgage, lenders can still threaten foreclosure. If you have a car loan, lenders can repossess your vehicle. Your bankruptcy debt management plan will only apply to your unsecured debts. If you file Chapter 7 bankruptcy, you may not have the financial means to pay your secured debts after the courts seize your liquid assets.
There are eligibility requirements
Not everyone will qualify for bankruptcy. If you wish to file Chapter 7 bankruptcy, you will need to pass a means test that proves your income is less than the median income for your family size in your state. You’re also required to receive counseling from an approved credit counseling agency.
If you fail the means test, Chapter 13 is your only bankruptcy debt settlement option. You are still required to meet with a credit counselor if you file for Chapter 13 bankruptcy. If you have more than $1,184,200 in secured debt or $394,725 in unsecured debt, you are not eligible to file Chapter 13 bankruptcy.
There is major damage to your credit score
Filing for bankruptcy can do major damage to your credit score. Bankruptcy remains in your credit history for 10 years. It's arguably the single worst event that can show up on your credit report. Many people believe that filing bankruptcy will give them a fresh start, but it could take years for this to be the case. Many lenders won't even consider an applicant if they have a bankruptcy filing in their credit report.
When you should declare bankruptcy
You should only file for bankruptcy if there are no other options, including debt consolidation. Filing for bankruptcy will harm your credit rating, and you'll feel the subsequent effects for years.
But, bankruptcy is a better option than sinking further and further into debt with no end in sight.
Debt consolidation — what you need to know
Debt consolidation occurs when you combine multiple debts into a single loan or credit card. The term "debt consolidation" is rather all-encompassing and includes things like balance transfer credit cards, debt consolidation loans, and credit card payoff apps like Tally.
Debt consolidation tools make it easier to track monthly payments. They may also provide access to a lower interest rate, saving you money in the long run.
The pros of debt consolidation
Debt consolidation should be a no-brainer for those with debt. Below are some of the primary advantages of debt consolidation.
Payments are simpler
If you struggle with making monthly payments on time, debt consolidation can help. Instead of having to worry about two or three payments, you only need to worry about one. If you use a debt consolidation loan, you'll have lower monthly payments, and the amounts are fixed.
You improve your credit
Proper debt consolidation management can help you build a good credit score. Making on-time payments is an excellent way to improve your credit score. You'll also lower your credit utilization ratio over time, which too will help boost your score, especially when the ratio falls below 30%.
Debt consolidation companies provide options
There are debt consolidation companies like Tally that exist to help you to make on-time payments, lower your interest rates, and save you money in the long run. Tally is a credit card payoff app that makes payments automatically, paying down your debt in the most strategic way possible. You can find a debt consolidation company that works well for you — as opposed to bankruptcy, which lets a court dictate the actions you must take.
You keep your assets
When you file bankruptcy, you may be required to turn over your liquid assets to the court. This is not the case with debt consolidation. When using a service like Tally, you decide how much or how little you'd like to put toward debt each month.
The cons of debt consolidation
Though debt consolidation is a useful option, there are some downsides that you must consider.
You must repay all debts
With bankruptcy, you can possibly write off outstanding debts, but with debt consolidation. you must repay all of the debts in your name. You may find this difficult if you are in a deep financial hole.
You may need a hard credit inquiry
If you take out a new loan or a new credit card to consolidate, your requesting financial institution will need to pull a hard inquiry on your credit. Doing so will cause a temporary reduction in your credit score — though making timely payments will quickly boost your score again.
When you should consolidate debt
If you have debt spread across multiple platforms, you should consider consolidating it. For instance, if you have debt with two credit card companies as well as student loans and debt from a personal loan, consolidation can make payments more manageable. Consolidating can allow you to reduce to one monthly payment at a lower interest rate, saving you money and boosting your credit score.
What is better: Bankruptcy or debt consolidation?
If you have debt, you may be wondering if it’s better to do debt consolidation or bankruptcy. Debt consolidation is usually the better option for numerous reasons. Debt consolidation allows you to build your credit score instead of ruining it. You can also keep your assets and have flexibility in how you choose to pay. Bankruptcy is generally only recommended as a last resort.
Be sure to check out Tally's app if you're looking for ways to consolidate existing credit card debt.