Debt consolidation or Chapter 13 bankruptcy: Which is right for you?

If you’re considering consolidating debt or filing for Chapter 13 bankruptcy, you’re likely facing serious financial distress. Both debt relief solutions may offer you a path to recovery but also present some challenges worth understanding. Here’s what to consider when making the choice between debt consolidation and Chapter 13 bankruptcy.

What is debt consolidation?

Debt consolidation usually means taking out a large loan from a creditor to cover the balance of all your existing loans and credit cards. The loan could be a personal loan from a bank, a peer-to-peer loan or, in some cases, a home equity loan. It is sometimes accomplished through a balance transfer. The goal is to get favorable terms that include a much lower interest rate than you’re paying on your multiple accounts; giving you the chance to reduce your payments and pay off debt in a reasonable time frame.

Related article: Considering a debt consolidation loan? Here’s what to look for

What is Chapter 13 bankruptcy?

Chapter 13 bankruptcy is a legal process that involves a structured repayment of your debts managed by a trustee over the course of three or five years. It’s one of the two most common forms of bankruptcy an individual or married couple can file. The other is Chapter 7. (This article explains the differences between Chapter 7 and Chapter 13.)

When does consolidation make sense?

If you have consistent income and don’t continue spendthrift behaviors that lead you further into debt, then consolidation may be an option for debt relief. If you consolidate before you’re delinquent on accounts, you can retain good credit.

However, if your credit is already impacted by your debt challenges, e.g., poor debt-to-income ratio, missed payments, etc., you may not be approved for a new loan or credit card account. Or, if you are approved, you may not get favorable terms. Consolidation is then not an option.

Ideally, under consolidation, you pay less, resolve debt in a few years and then move forward with financial goals. If you instead continue using the credit cards you’ve paid off while still paying on your consolidation loan, you may find yourself deeper in the debt hole.

Related article: 5 keys to successful debt consolidation

Is Chapter 13 the right option?

“Chapter 13 is not a great option for most people but a palatable one if you’re in the right set of circumstances where you can’t file Chapter 7, you can’t come up with the money to settle, or you need creditor protection,” says Michael Bovee, co-founder of Resolve. He advises those who don’t qualify for Chapter 7 to look at other debt relief solutions, such as debt settlement, before filing Chapter 13.

The biggest benefit to filing bankruptcy is that you’re under court protection, which eliminates judgments, liens and wage garnishments, and stops all collections; even a foreclosure. There are drawbacks to Chapter 13 bankruptcy in that it takes several years to complete, involves a rigid repayment plan and stays on your credit for seven years. Plus, you may find it’s not as affordable as filing Chapter 13, which can begin at $3,000.

What’s most concerning, though, is that roughly only one third of those who file Chapter 13 complete it. That’s because the repayment plan doesn’t offer any flexibility. This means if you enter Chapter 13 and in six months a costly emergency arises or your income changes and you miss one payment, your bankruptcy will be dismissed, you’ll lose your court protection and you’ll again owe the full amount of your debts.

“There’s a lot of literature out there about how abusive to consumers [Chapter 13] is,” says Robert Haupt, a bankruptcy attorney with Lathrop Gage LLP. He explains that lawyers get their fees whether or not Chapter 13 is the right solution for their client and even if the client is unable to complete their plan.

Assessing debt consolidation vs. Chapter 13

There are online tools to help you assess debt consolidation. First, look at the total debt you have and the average interest rate you’re paying. Figure out how long it will take to pay off each card using a credit card payment calculator. Then review your budget to assess how much you can pay toward your debt each month. Use this debt consolidation calculator to determine the loan terms that will work for you. Then check with potential lenders to find out if you qualify for these terms. And be sure to consider if you have the discipline to either close the accounts you’re paying off or use them only in cases of emergency.

To assess your qualifications and options for filing bankruptcy, it’s best to speak with a bankruptcy attorney. Although you can file bankruptcy yourself, an attorney will bring knowledge and experience that can make their fees worth paying. Plus, most offer a free, no-obligation consultation.

Related article: How to file Chapter 13 bankruptcy