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Debt Consolidation Vs. Bankruptcy: When To Consider Each

Debt consolidation is often preferable to bankruptcy, but for some, it may not be enough.

Updated Dec. 10, 2024
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If you're overwhelmed by debt, debt consolidation and bankruptcy are two potential solutions.

Debt consolidation can make your monthly payments more manageable without destroying your credit, but you'll still have to pay off your debt. Bankruptcy is a more drastic choice that can damage your credit for years, but it might be worth considering if you can't make reduced monthly payments or qualify for a consolidation loan.

We recommend debt consolidation for people who can pay off their debt but could benefit from simplified — and potentially lower — monthly payments. Bankruptcy might be better for people who are overwhelmed by bills they can't pay and have exhausted all other options.

In this guide, we’ll cover the different types of bankruptcy and debt consolidation programs that can help you get the relief you need.

Main differences between debt consolidation and bankruptcy

Before we go into detail about how debt consolidation and bankruptcy work, here’s a quick rundown of the primary differences between the two.

Debt consolidation Bankruptcy
Impact on total debt Does not reduce your debt Eliminates most unsecured debt
Repayment Consolidates multiple debts into one monthly payment based on loan term May involve a payment plan based on your disposable income
Assets Keeps your assets protected from creditors May involve liquidating your assets to pay back creditors as much as possible
Credit requirements May require fair or good credit No credit score requirements
Credit impact Can help or hurt your credit Hurts your credit
Credit report Hard inquiries for new loans can stay on your credit report for up to two years Stays on your credit report for seven to 10 years
Cost Doesn't typically cost money unless you enter a debt management plan Can cost hundreds or thousands of dollars to file

Debt consolidation: What it is and how it works

At a basic level, debt consolidation is the act of combining multiple debts into one. There are two main ways to consolidate debt. The first is by taking out a new debt consolidation loan, generally an unsecured personal loan, to combine debts from other loans and/or credit cards. The second is through a paid debt management plan (DMP) with a credit counseling agency.

Good to know
Debt consolidation isn’t the same as debt settlement, which involves negotiating with creditors and paying less than you owe.

Pros
  • It isn’t likely to do as much damage to your credit compared to bankruptcy.
  • Your assets remain protected from your creditors.
  • You can qualify for a lower interest rate to save money.
  • You can do it yourself or with the help of a co-signer or credit counselor.
  • It typically costs less than bankruptcy.
Cons
  • You may not qualify for a low enough interest rate on a consolidation loan.
  • Consolidating with a debt management plan can hurt your credit and be costly over time.
  • It may not be enough for extreme circumstances.

Debt consolidation loans

Banks, credit unions, and online lenders offer personal loans that borrowers can use to consolidate other debts. Interest rates, fees, and other terms can vary by lender, but there are options available for just about any credit profile. Consolidating debt can be a good reason to take out a new loan, and we’ve found that most lenders permit funds to be used for this purpose.

Taking on new debt to pay off old debt may sound counterintuitive. But doing so can help you combine multiple loans into one, simplifying your repayment plan. Even if your credit history isn’t stellar, getting approved for a debt consolidation loan with bad credit is still possible.

However, we only recommend going this route if you can get a lower interest rate than you currently pay or lower monthly payments. For instance, if you’re trying to consolidate two loans with annual percentage rates (APRs) of 18% and 21% but only qualify for a new loan with a 23% APR, you’ll pay more in interest. But this can make sense if you need longer to pay off your debt and can take out a loan that translates to smaller monthly payments.

Some lenders let you apply with a cosigner, who may help you get approved for better terms. Keep in mind, though, that not all lenders allow cosigners. Also, your cosigner will be responsible for repaying the debt if you can’t, so their credit — and yours — are both on the line.

Explore lenders
Some of the best debt consolidation companies include LendingClub, Upstart, and Best Egg.

Debt management plans

If your debt situation is more dire but not to the point where you want to declare bankruptcy, we might suggest a debt management plan (DMP).

Credit counseling agencies offer DMPs to help you consolidate unsecured debts into one monthly payment. DMPs often take three to five years. Instead of a new loan, a credit counselor takes a single monthly payment from you and distributes it to your creditors on your behalf. Why? Credit counseling agencies often have contracts with lenders that offer them lower rates than you pay. Average rates range from 8% to 12%, which can be much lower than credit card APRs. When you’re on a DMP, you’re guaranteed to make steady progress on your debt.

But for all the advantages of DMPs, we want to share some warnings:

  • You typically need to agree to stop using your credit accounts, specifically credit cards, during the repayment plan.
  • Your creditors can note on your credit report that you’re no longer paying your debt as initially agreed. While that won’t hurt your credit score as much as a bankruptcy, it can still make it difficult to get approved for credit.
  • Expect to pay around $30 to $50 upfront and up to $75 monthly for a DMP.

Bankruptcy: What it is and how it works

There are two types of bankruptcy: Chapter 7 and Chapter 13. Depending on your situation and goals, one may be better for you — but we want to be clear that neither is ideal. Filing for bankruptcy has benefits and drawbacks, so consider these carefully.

Pros
  • Can result in the discharge of some or all of your debts.
  • Stops creditors from making collection attempts, including foreclosure and repossession.
  • Some assets may be exempt from liquidation.
Cons
  • A bankruptcy remains on your credit report for seven to 10 years.
  • Hiring an attorney to represent you can cost a few thousand dollars.
  • You may lose much of your property.
  • You’re beholden to the court’s decision

Chapter 7 bankruptcy

Also known as liquidation bankruptcy, Chapter 7 bankruptcy eliminates most of your debts. But this comes at a very high price.

The catch, as attorney David Reischer and CEO of LegalAdvice.com puts it: “An individual who enters Chapter 7 Bankruptcy liquidates most of their assets with limited exceptions to pay off creditors.” Depending on the value of your assets, they may cover part or all of what you owe.

Exempt debts
Keep in mind that student loans, alimony and child support, and back taxes are typically exempt from bankruptcy.

To qualify for Chapter 7 bankruptcy, you need to pass a means test to prove that your income and expenses make it impossible for you to repay what you owe.

You’ll also pay to file. The cost of filing is $335 for Chapter 7 bankruptcy in central California, for example. But if you hire an attorney to represent you, you’ll also be responsible for paying their fees, which can be in the thousands of dollars.

Chapter 13 bankruptcy

Often referred to as reorganization bankruptcy, Chapter 13 bankruptcy assists you and your creditors in setting up a court-mandated payment plan to satisfy some or all of your debts. The plan typically takes three to five years, and your monthly payments are based on your ability to pay.

Chapter 13 bankruptcy is designed for people with regular income, says Reischer. “They get to keep most or all of their property so long as they pay off their debt obligations through a repayment plan.”

In other words, Chapter 13 bankruptcy is less likely to cause an upheaval of your entire life. That said, you typically can’t take on any new debt during the repayment process without approval from the court-appointed trustee, who’s responsible for distributing your payments to your creditors.

Also, once the payment plan is in place, you’re required to stick to it. If you don’t, the court may dismiss the case, putting you at the mercy of your creditors, or convert it to a Chapter 7 bankruptcy.

Chapter 13 bankruptcy is added to your credit report and remains there for seven years after filing. The filing fee is $310 in central California, but remember to factor for attorney fees.

How to choose between bankruptcy and debt consolidation

In general, debt consolidation provides relief on much softer terms than bankruptcy. But that doesn’t mean it’s the right answer in every case.

Make sure you understand your options and financial situation.

When to choose debt consolidation

Your debts are manageable

If you’re tired of making monthly payments but are generally financially secure, a consolidation loan is likely your best bet. If you have great credit, you may qualify to lower your interest rate. This would mean paying less in interest overall and possibly getting out of debt faster.

You’ve missed a payment or two

If you feel like you’re starting to slip with your debt obligations, a debt consolidation loan could help you simplify your repayment. You can take out a longer loan to buy yourself more time and lower your monthly payments. And if you have a good credit history or a cosigner with one, you may save money while you’re at it.

You’re behind but aren’t yet in collections

If you fall too far behind on payments, your creditors may sell your debts to collection agencies. Not only will that have a bigger negative impact on your credit score, but debt collectors are also typically more aggressive in trying to get you to pay.

If you’re not quite there yet, but your credit has already taken a hit from the delinquencies, a consolidation loan with a cosigner may still be an option.

Pro tip
If you anticipate having trouble affording or qualifying for a consolidation loan, we suggest chatting with a credit counselor at the NFCC about a debt management plan. This will be better than resorting to bankruptcy in many cases.

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When to choose bankruptcy

You have multiple debts in collections

If your debt situation is entirely unmanageable and you’re constantly trying to dodge collection calls, it may be too late to get a debt consolidation loan or get on a DMP. You could try settling your debt, but it’s usually at this stage that we see people start considering bankruptcy.

You're at risk of losing your assets or having your wages garnished

If you're facing foreclosure, repossession, or wage garnishment and can't reach an agreement with your creditors, filing for bankruptcy might help you protect your assets. Doing so temporarily stops all collection efforts, in most cases, and while it's possible to lose assets in bankruptcy, you can exempt certain assets.

Depending on your financial situation, Chapter 7 or Chapter 13 may be more appealing. Consider consulting with a bankruptcy attorney to get a better idea of which option is best for your situation.

“An experienced bankruptcy attorney will be better able to navigate the process,” says Reischer. “At the very least, they should be able to inform a client whether a debt consolidation loan is a better option than filing for bankruptcy.”

While hiring an attorney can be expensive, you can often get the initial consultation for free.

Bottom line

Dealing with debt is never a fun experience. But if you don’t address the problem now, it can get worse over time. If you’re looking for ways to get rid of your debt, debt consolidation and bankruptcy are both worthy options to consider.

The right option for you, however, depends on your financial situation and your goals. Take the time to consider each carefully. If you’re unsure or too stressed to take the next step, consider consulting with an attorney or credit counselor. They can help you understand each option and how they relate to your situation and help you choose the one that will provide you with the best path forward.

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Author Details

Ben Luthi

Ben is a personal finance and travel writer who loves helping people achieve their money goals. Along with FinanceBuzz, his writing has also been featured on U.S. News, NerdWallet, Experian, Credit Karma, and more.

Author Details

Elizabeth Aldrich

With nearly a decade of experience as a financial journalist and editor and a degree in economics, Elizabeth Aldrich has worked on thousands of articles on banking, credit cards, investing, loans, consumer finance, and travel. Her work has been featured in Forbes Advisor, USA Today, Bankrate, Business Insider, Investopedia, and more.