Bankruptcy vs. debt consolidation: How to choose

Today’s high interest rates and record inflation are causing more people than ever to struggle with debt payments. If that sounds familiar, you might be pondering the differences between debt consolidation vs. bankruptcy too. In fact, bankruptcy filings rose by 17% in 2023, while unsecured personal loan debt — a common debt consolidation tool — increased by 11% as well. 

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Generally speaking, if you can afford to repay your debt, debt consolidation loans are better than bankruptcy. That often falls into a bit of a gray area, however, and it doesn’t capture all of the points you need to weigh when deciding which is better: debt consolidation vs. bankruptcy. We’ll give you a quick run-down on how to choose between the two, as well as your other options. 

What is debt consolidation?

Debt consolidation refers to the process of borrowing low-cost funds to pay off high-interest debt. A common example is using a personal loan to pay off debt such as credit card balances. 

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Loans generally charge lower interest rates than credit cards, so more of your money goes toward paying down the debt rather than toward interest. Plus, you’ll get a steady monthly payment that won’t change over time, and you have more flexibility to choose a term length that’ll make payments affordable for you. 

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Pros

• Can help build credit score
• Streamlines debt repayment
• May be able to refinance later
• Possibility for lower interest rate
• Potential for low (or no) monthly payments

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Cons

• May require good credit
• Doesn’t erase any debts
• Can charge expensive fees 
• May take a long time to pay off
• Generally requires steady income
• Can cost more total interest over time
• Requires a lot of discipline if using limited-time offers
• Doesn’t stop debt collectors, lawsuits, or wage garnishments

Types of debt consolidation

You’ll need some way to borrow money at a lower rate than you’re already paying in order to make consolidating debt work. Personal loans are a popular choice for this, but they’re not your only option. You can also tap into your home equity to get more affordable rates, although many financial experts recommend exercising caution because the debt is tied to your home. 

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Here are the most common sources for a debt consolidation loan and how they compare:

Personal loans

Personal loans are unsecured, meaning they’re not attached to any collateral as with a home equity product. You’ll pay slightly higher rates (typically around 12%), but in return, your home isn’t at immediate risk of foreclosure if you can’t make your payments. 

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Most personal loans offer fixed rates and come with term lengths ranging from one to 10 years. You can often receive personal loan funds very quickly (sometimes as fast as the same day), with many no-fee personal loans available online.

Balance transfer credit card

Balance transfer cards are a type of credit card that offers a special promotion after you first sign up: you’ll get a lengthy period (often a year or more) with no interest charged on other credit card balances you transfer over. If you can make quick progress in paying off your credit card debt, this can be a great option. 

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Many of these cards charge balance transfer fees ranging from 3% to 5%, but even with this fee, it’s often a more cost-effective option. Once the promotional period ends, the interest rate on your remaining debt will go back up to the normal level for the remainder of that card’s life. 

Home equity investments

A home equity investment (HEI) is a way to leverage the equity you’ve built up in your home without having to take on any new debt. When you partner up with a home equity investment company, you’ll receive a lump sum of funds, to be repaid 10 to 30 years in the future. In lieu of interest, you’ll pay a share of your home’s future equity. 

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An HEI is different from a traditional loan, so it requires no monthly payments and has more lenient requirements. The tradeoff is that you’ll need to make a large balloon payment in the future, possibly by selling your home. In addition, the amount you have to repay — while capped — depends on your home’s future value, so there’s no way to compare the cost of the financing in advance. 

HELOCs/Home equity loans

A home equity line of credit (HELOC) or home equity loan offers another way to borrow against your home’s equity. These products are also known as “second mortgages” since they’re also tied to your home as collateral — and just like a mortgage, they typically come with steep closing costs. They generally charge lower rates (around 8.5% for a HELOC and 7.5% for a home equity loan) and are available with a wide range of term lengths lasting from one to 30 years.

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A home equity loan will offer you a lump sum with affordable financing, perfect to pay off your debt in one fell swoop. Choose lines of credit instead if you want more flexibility to borrow again while you’re in the draw phase, or to make interest-only payments. You’ll switch to repaying the entire loan — interest and principal — during the repayment phase if you haven’t already done so. 

What is bankruptcy?

Bankruptcy is a court process that can wipe away many — but not all — types of debts, either immediately or after a few years of making payments. Non-dischargeable debts include things like past-due taxes, child support, fines, and alimony. Student loans may be discharged, but only in very rare cases of exceptional hardship. Secured debts like mortgages and car loans aren’t able to be discharged; but depending on where you live, what type of bankruptcy you file for, your ability to make payments, and the value of your collateral, you may be able to keep some or all of these items.

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Bankruptcy is a very involved process and while you can DIY it, experts are unanimous that you should work with a lawyer because of the complexities, filing requirements, and the high stakes involved. Many important parts of filing for bankruptcy also rely on interpreting state law, which can vary a lot around the country. 

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Pros

• Must go through financial counseling
• Regular income isn’t always required
• May completely erase some or all debts 
• Stops debt collectors, lawsuits, and wage garnishments

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Cons

• Can lose some of your assets
• Means testing may be required
• Requires a lengthy court process
• Not all debt types are eligible for discharge
• High failure rate for Chapter 13 bankruptcy
• Your financial information is available for the public to view
• Significant and long-lasting negative impact on your credit score
• Very expensive after paying court costs, attorney fees, and other charges

Types of bankruptcies

There are several types of bankruptcy, depending on who’s filing (individuals vs. businesses) and your financial situation. If you’re filing for bankruptcy in your personal life, you’ll need to choose between Chapter 7 and Chapter 13 bankruptcy. Here’s how they differ:

Chapter 7

A Chapter 7 bankruptcy case is the typical one most people think of, where the court orders a trustee to sell a person’s assets in order to repay their creditors, with the remaining eligible debts being forgiven. Depending on which state you live in, however, some or all of your assets may be exempt from being sold; in fact, 96% of people who file for bankruptcy under Chapter 7 get to keep all of their belongings. 

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In order to qualify, however, you’ll need to pass a means test. If you do, you can expect the entire bankruptcy process to take between three and four months, however, the negative mark will stay on your credit report for up to 10 years. 

Chapter 13

A Chapter 13 bankruptcy functions more like a repayment plan. The court has a pre-set formula to determine a reasonable payment amount for you, and depending on your income level, you’ll pay the same amount each month for three or five years. After you complete the payment plan, and remaining eligible debt will be forgiven. This is a better option if you want to keep property that you would otherwise lose in a Chapter 7 bankruptcy and you have the income to keep up with payments. 

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It’s especially important to keep in touch with your bankruptcy trustee if you run into problems given the lengthy legal contract you’re signing up for. Indeed, only about one-third of Chapter 13 filers actually end up completing their plans and receiving a debt discharge. A Chapter 13 bankruptcy mark will stay on your credit report for seven years, instead of 10. 

Debt consolidation vs bankruptcy: Which is better

Debt consolidation may be a good idea if:

• You want to preserve your credit score.
• You can qualify for something offering better terms.
• You want to keep assets that could be taken in bankruptcy.
• You have more secured debts and student loans than unsecured debts.

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Bankruptcy may be a good idea if: 

• You’ve tried other options and it hasn’t worked.
• There is no way you can repay the debt within a reasonable amount of time.
• You’re able to work with a lawyer and the courts to go through legal proceedings.
• You want to stop debt collectors, lawsuits, and wage garnishments in their tracks.
• Your financial problems come from debts that bankruptcy can actually handle, rather than secured debts and student loans.

Final thoughts

Each year thousands of people find themselves trying to decide between bankruptcy vs. debt consolidation. For most people, the choice boils down to a couple of factors: Can you qualify for a better financing offer and keep up with the payments? Are you planning on applying for credit in the next few years? If so, a debt consolidation loan might be a better option for you. If not, you may be leaning toward bankruptcy. 

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You don’t have to make the decision alone, however. If you don’t have access to a financial advisor who can provide unbiased advice, try contacting the National Foundation for Credit Counseling in order to speak with a live debt counselor for free. They’ll be able to help you assess your situation, develop a budget, and advise you on the best course of action and your alternatives. Plus, if you do settle on bankruptcy, you’ll be required to speak with a nonprofit credit counselor as a part of the court-mandated requirements anyway. 

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