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Debt Consolidation vs. Bankruptcy


If you are struggling financially, you are likely researching your options. Should you try debt consolidation or file bankruptcy?

Both debt consolidation and bankruptcy have pros and cons, which Philadelphia bankruptcy lawyer David M. Offen will explain in depth in this article.

If you have further questions, call the Law Offices of David M. Offen at (215) 625-9600 for your free, no-obligation consultation to discuss how your unique financial situation might best be solved.

Debt Consolidation Explained

Debt consolidation is the term used when an individual’s debts are compiled and then paid off over time, usually by a company providing this service. A debt consolidation company enters into contracts on your behalf with each creditor and pays them a pro rata share of what you pay the agency every month until the debt is paid.

Sometimes creditors will accept somewhat less than you owe — this is called debt settlement. Be advised that you may incur some income tax liability if a creditor forgives part of your debt. This is not the case if you get that same debt discharged in bankruptcy.

Debt Consolidation Loans

If you have equity in your house or a high credit score and are looking to simply consolidate your debt into one monthly payment, you might consider taking out a debt consolidation loan. A debt consolidation loan will carry a much lower interest rate than any credit card and may make paying off your debt more affordable, especially if you have suddenly experienced financial hardship such as a reduction of work hours or job loss.

A debt consolidation loan is not “debt consolidation,” which is a payoff plan brokered by a private company on your behalf. A debt consolidation loan pays off your creditors so that the debt is marked “paid as agreed” on your credit report. 

If you can obtain a debt consolidation loan, it often carries less interest than the debt that you want to consolidate, so it is a money-saving option. However, a low credit score will preclude many people from being approved for such a loan.

Pros of Debt Consolidation

  • One low monthly payment
  • Interest rate is often lower than the debts you are consolidating
  • One due date so you don’t have to keep track of when multiple bills are due
  • The fewer creditors you have, the more successful debt consolidation can be

Cons of Debt Consolidation

Your creditors are not required to participate in your debt consolidation plan, meaning that you may attempt to consolidate your debt only to have one or two creditors refuse and insist on being paid individually. If you cannot afford to pay these creditors as well as your monthly debt consolidation payment, they can still put your account in collections, harass you with phone calls and collection letters, and sue you.

If creditors obtain a judgment against you, they can levy your bank accounts, and in some cases, garnish your wages. If even one creditor does not accept the consolidation plan, as often happens, and you can’t pay the creditor as well, then the whole approach of debt consolidation will fall apart. 

A debt consolidation plan, whether successful or not, negatively impacts your credit score because you are not paying these debts as you agreed in your contracts with individual creditors. This impact can last up to seven years on your credit report.

Bankruptcy Explained

Bankruptcy is a federal legal process through which individuals and businesses can reorganize their debt and get unaffordable debt discharged, meaning, they are no longer responsible for paying that debt. 

Chapter 7 bankruptcy and Chapter 13 bankruptcy are most commonly filed by individual debtors. Businesses may liquidate through Chapter 7 or may file Chapter 11 to reorganize their finances.

Pros of Bankruptcy

  • All of your creditors are legally required to comply with the bankruptcy process.
  • The automatic stay prevents your creditors from taking collection actions against you, including phone calls, letters, lawsuits, garnishment, and bank account levies, as well as foreclosure and eviction.
  • You are discharged of unaffordable debt such as credit cards, medical bills, and personal loans, and you may be able to get income tax discharged.
  • You can legally surrender any unaffordable collateral, such as real property or a car that you do not wish to keep. People do this when, for example, their house has gone way down in value or needs a lot of repairs, or their car needs expensive repairs. You can then have the underlying debt discharged.
  • You can pay off past due debt such as child support, spousal support, student loans, mortgage payments, and car loan or lease payments over time through a Chapter 13 plan.
  • You can strip off second mortgages or HELOCs as unsecured in Chapter 13.
  • You can cram down your car loan to the current retail value of the car and pay that amount off in your Chapter 13 plan, at prime plus 1-3% interest.
  • You can pay off your car lease balloon payment in your Chapter 13 plan.

Filing for Bankruptcy

In exchange for the protection of the automatic stay and opportunity to discharge unaffordable debt and catch up with past due debt, you must disclose your income, assets, expenses, and debts in your bankruptcy filing. To be eligible to file Chapter 7, you must pass the Chapter 7 means test. To file Chapter 13, you must show steady earnings or regular monthly income, such as regular support from family members in an amount that covers your expenses and the monthly Chapter 13 plan payment.

Which is Better: Debt Consolidation or Bankruptcy?

There is no firm answer to this because every individual’s financial situation, including liabilities and goals, is unique to them. 

Consider the advantages and disadvantages described in this article and discuss your situation with an experienced bankruptcy attorney. Your attorney will help you understand what debt consolidation and bankruptcy offer you and whether you have additional options, such as taking out a home equity loan to pay your debt. You need to consider that if you take out a home equity loan and are unable to make the required payments, the creditor is permitted to file a mortgage foreclosure action against the home. You might also consider refinancing or modifying your mortgage, or pursuing debt settlement negotiations.

How Debt Consolidation and Bankruptcy Affect Your Credit Score

Both debt consolidation plans and bankruptcy have an impact on your credit. 

Debt consolidation, even if successful, can remain on your credit report up to seven years, as can a Chapter 13 bankruptcy filing. Chapter 7 bankruptcy can remain on your credit report for up to ten years. That said, many who successfully file bankruptcy find that their credit score rises somewhat because their debt-to-income ratio improved dramatically following discharge.

There are steps you can take to rehabilitate your credit following any action you take to deal with your debt situation. For example, you might take out a secured credit card, use it for usual expenses such as groceries, and pay it off each month to build credit. And while you are not eligible for the most advantageous interest rates, you might take out a car loan and by making those payments in full and on time each month, further build good credit.

Talk with an Experienced Bankruptcy Attorney

There is no one-size-fits-all solution to solving debt problems. You deserve to have your individual financial situation and goals assessed by a seasoned bankruptcy attorney with over 20 years’ experience helping people solve their debt problems. Call us today and discuss your case, free of charge.

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