Debt consolidation vs. bankruptcy: What’s the difference?

If you’re on the brink of going deeper in debt and facing late payment fees, you may be considering debt relief options. Debt consolidation vs. bankruptcy? Both are worth considering to get on a path to a clean financial slate. Here’s what you need to know about each in order to make the best decision for your financial situation.

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. Sometimes it can be 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, which gives you the chance to reduce what you owe and pay off debt in a reasonable time.

What is bankruptcy?

Bankruptcy laws give those who have more debt than they can repay a way to get a fresh start. Depending on the type of bankruptcy filed, consumers can gain court-ordered protection from creditors, discharge unsecured debts entirely or enter an organized repayment plan. There are several types of bankruptcies, but Chapter 7 and Chapter 13 are the most common for individuals and married couples.

Related article: Bankruptcy: The differences between Chapter 7 & Chapter 13

“Bankruptcy is not the nightmare it’s made out to be by a lot of folks, but it does damage your credit,” says Michael Bovee, co-founder of Resolve, a free financial management platform. “But the fact is, there’s a time for it. Even if you can do other things to tackle a mounting debt problem, bankruptcy can prove to be the right option.” Bovee, who rarely recommends Chapter 13, says that for those who qualify,  Chapter 7 bankruptcy is the fastest, lowest-cost debt relief solution.

Comparing the pros & cons of consolidation vs. bankruptcy

Debt consolidation may be an option if you have consistent income and rein back spendthrift behaviors that could cause your debt to snowball again. If you consolidate before you fall behind on payments, you could retain good credit. But if your credit is already suffering from missed payments, a poor debt-to-income ratio or other black marks, you may be unable to get a new loan or credit card account or, if approved, you may not get favorable terms. Consolidation is then not an option.

Ideally, under debt consolidation, you pay less and resolve your debt in a few years. If you maintain good spending habits, you’ll be able to move forward with your financial goals.

Related article: 5 keys to successful debt consolidation

But despite the best of intentions, people often slip back into old money habits, which is why Robert Haupt, a bankruptcy attorney with Lathrop Gage LLP, cautions against going that route.

“Consolidators are taking your money and making money off of it,” he says. “I don’t think I ever saw a situation where I thought debt consolidation was the right answer.”

On the other hand, bankruptcy can be a cost-effective, faster solution to debt. Chapter 7 is usually the lowest-cost and quickest option, typically completed about 90 days after filing. As soon as you’ve dissolved your debts, you can start rebuilding your credit. Chapter 13 is a longer process that takes up to five years, so expect to postpone your financial goals for at least that time. A big benefit, though, is that with bankruptcy you’re under court protection, which eliminates judgments, liens and wage garnishments as well as stops all collections, including a foreclosure.

However, bankruptcy is not a light decision because of the seven- to 10-year fallout on your credit and the impact on your short-term financial goals. You can face forced liquidation of some assets under Chapter 7. Chapter 11 and 13 require strictly structured payment plans over time. Only about a third of those who file Chapter 13 complete it, because it doesn’t offer any flexibility in payment schedule or amount if an unexpected, costly emergency arises or your income changes.

Related article: 6 steps to rebuild your credit after bankruptcy

How to assess debt consolidation vs. bankruptcy

As you consider debt consolidation vs. bankruptcy, take an honest look at the amount of your debt, your budget and your available funds and income. Identify your short- and long-term financial goals and how your credit health will impact these.

To best assess your qualifications and options for filing bankruptcy, speak with a bankruptcy attorney. Although you can file bankruptcy yourself, an attorney’s knowledge and experience can be worth the legal fees. Plus, most attorneys offer a free, no-obligation initial consultation.

To consider debt consolidation, look at the total debt you owe 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 what loan terms will work for you. You’ll need to check with potential lenders to find out if you qualify for these terms. Be sure to consider if you have the discipline to either close the accounts you’re paying off or use them only in an emergency.