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

Debt consolidation with a personal loan or bankruptcy: Both are debt solutions, but one is better than the other. (Shutterstock)

Debt consolidation and bankruptcy are two options for dealing with overwhelming debt. Both provide a long-term solution to your debt, but they work very differently and have varying credit consequences. 

A personal loan can be a good tool for consolidating high-interest debt. Credible makes it easy to see your prequalified personal loan rates from various lenders, all in one place.

• Debt consolidation vs. bankruptcy
• What to know about debt consolidation
• What to know about bankruptcy

Debt consolidation vs. bankruptcy

Both debt consolidation and bankruptcy can help you manage debt, but it’s important to understand how each one works before deciding which option makes sense for you. Here are some key differences between debt consolidation and bankruptcy. 

Debt consolidation

Debt consolidation merges multiple debts into one, usually by taking out a new loan or balance transfer credit card to pay off your existing debt balances. This option is best suited for those who can pay off their debt but are having trouble managing multiple monthly payments or high interest rates.

Debt consolidation may harm your credit in the short term since it requires taking on new debt. But it can boost your credit in the long run as you pay off your debt. Debt consolidation may have a small cost associated with it in the form of a loan origination fee or balance transfer fee, if you’re using a balance transfer credit card to consolidate.

The amount of time it’ll take you to get rid of your debt depends on the debt consolidation route you choose, the amount of debt you have, and the amount you can afford to pay each month. But it may be possible to be debt-free within five years.

Bankruptcy

Bankruptcy is another debt solution, but with a very different process and different ramifications. Unlike debt consolidation, bankruptcy is a legal proceeding. And instead of helping you consolidate your debts or get lower interest rates, it helps you get rid of your debts altogether.

If that sounds too good to be true, know there are serious downsides. First, not all types of debt can be discharged in bankruptcy, so you may still find yourself stuck with some of the debt. 

What to know about debt consolidation

In most cases, debt consolidation involves taking out a personal loan to pay off your other debts. You’ll then only have one debt with one monthly payment to worry about. In some cases, you may qualify for a lower interest rate than what you were paying on your other debts, which can also save you money in the long run. 

Debt consolidation can also be done in other ways, including using a balance transfer card to manage credit card debt or a home equity loan or home equity line of credit (HELOC) to pay off your debt.

Pros of debt consolidation

• Streamlines debt repayment — Debt consolidation can help you go from multiple monthly payments and interest rates to just one. Not only is it easier to keep track of your debts, but you could also end up paying less each month.
• May get a lower interest rate — Debt consolidation can result in a lower interest rate, especially if you’re consolidating high-interest debt like credit cards or using a secured debt like a home equity loan to consolidate your debt.
• Can improve your credit — While you may see a temporary drop when you open the new debt, debt consolidation may improve your credit utilization and make it easier to make on-time payments each month.
• Get out of debt sooner — With a potentially lower monthly payment and interest rate, debt consolidation could help you pay off your debt more quickly. Depending on how much debt you have, it could take as much as several years or as little as a few months to become debt-free.

Visit Credible to compare personal loan rates from various lenders, without affecting your credit.

Cons of debt consolidation

• May pay fees — Debt consolidation may come with added costs in the form of an origination fee on a personal loan or home equity loan, or a balance transfer fee on a credit card. Factor in the additional fees to make sure that consolidating your debt will make financial sense.
• Interest rate may not be lower — There’s no guarantee that debt consolidation will result in a lower interest rate. Personal loans can have high interest rates, especially for borrowers with poor credit. If you already have low interest rates on your current debts, then consolidating the debt might not be advantageous.
• Assets could be at risk — Depending on the type of debt consolidation you use, you could be putting other assets at risk. For example, a home equity loan is secured by your home, meaning your lender could foreclose on your home if you stop making your payments.
• May not get to the root cause of spending — If you haven’t addressed the root cause of your debt, then your debt consolidation loan could help you pay off your credit cards but tempt you to use them for additional purchases. As a result, you may find yourself in an endless debt cycle.

What to know about bankruptcy

If your financial situation is dire and you’re considering bankruptcy, these are the two different types: 

• Chapter 7 bankruptcy — This type of bankruptcy allows you to have certain debts discharged. In return, your non-exempt possessions will be sold to help provide some compensation to your creditors. What’s considered exempt property depends on your state but could include work-related items, a personal vehicle, equity in your personal residence, and home furnishings.
• Chapter 13 bankruptcy — With Chapter 13 bankruptcy, a court representative will help you create a repayment plan rather than discharging your debts. You’ll make installment payments to your creditors for a certain number of years, and in exchange you can keep all your property. Any remaining debt at the end of the repayment term will be discharged.

It’s important to note that some debt can’t be discharged in Chapter 7 bankruptcy. Debt that won’t be discharged includes child support, alimony, taxes, and student loans. Chapter 7 bankruptcy also has an income limit. Those who wish to file for bankruptcy and aren’t eligible for Chapter 7 can use Chapter 13 instead.

Pros of bankruptcy

• Can provide debt relief — Bankruptcy can provide relief from your debt and, in the case of Chapter 7 bankruptcy, help you discharge some of your debts entirely.
• May help you avoid foreclosure — Bankruptcy can help you avoid legal judgment or foreclosure as a result of unpaid debts.
• Some possessions will be taken — While some of your personal possessions will be liquidated to pay off credits, others will be exempt from liquidation.
• May not lose all your possessions — In the case of Chapter 13 bankruptcy, you may be able to keep your possessions while still having some of your debts discharged.

Cons of bankruptcy

• Lasting credit effects — Bankruptcy remains on your credit report for up to 10 years and could prevent you from borrowing money, renting an apartment, qualifying for insurance, or even getting certain jobs.
• Could lose your possessions — Depending on the type of bankruptcy, you could end up having many of your personal possessions taken and liquidated to make payments on your debts.
• Not every debt is eligible for discharge — Certain debts, including student loans and child support, aren’t eligible to be discharged during bankruptcy.
• May have to pay fees — Bankruptcy can result in additional court, administrative, and attorney fees during a time when you’re already struggling to pay what you owe.

Bankruptcy should be considered as a last resort. Consider a personal loan for debt consolidation instead. You can quickly and easily compare personal loan rates with Credible to find one that suits your needs.