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- Debt consolidation lowers your interest rate, while bankruptcy clears your total debt.
- While bankruptcy devastates your credit score, consolidating debt may help your credit.
- Those who cannot pay their debts back should consider bankruptcy, and those with manageable debt should consider consolidating debt.
Nearly everyone who owes money to creditors thinks about how they can reduce or eliminate their debt. Depending on your situation, declaring bankruptcy or consolidating debt can be good options. However, each borrower must carefully consider which approach makes the most sense or if neither is a good choice.
"Each debt relief option comes with different types of benefits and costs, as well as potential risks," says Renauld Smith, executive director of IAPDA Certification, a non-profit organization that certifies and accredits debt settlement companies.
Difference between debt consolidation and bankruptcy
While bankruptcy and consolidation will help you pay off your debt, they vary drastically in method. Debt consolidation focuses on simplifying your debt at a lower interest rate, while a bankruptcy will clear the debt you owe your creditors. These two methods also differ in how they affect your credit.
Before we get into the differences, let's first quickly go over both debt relief method.
Bankruptcy
Bankruptcy is the most severe debt relief option for the most severe debt problems. Typically, you'll be able to lower your total debt to a manageable amount with a debt settlement. The best debt settlement services can help you cut your debt down to a third of what you originally owed. But if a debt settlement isnt enough, you may have to pull out that last resort and declare bankruptcy.
While there are six types of bankruptcies, individuals who file for bankruptcy generally have two options: Chapter 7 and Chapter 13.
A Chapter 7 bankruptcy is known as liquidation bankruptcy in which all of a debtor's nonessential assets — luxuries, collectors items, expensive clothing — are sold off to pay back their creditors. Once those proceeds are divided amongst the creditors, the debtor's remaining debts are discharged, and the debtor is no longer responsible for paying off those debts, essentially given a blank slate. The entire process takes a few months.
If a debtor makes a significant amount of money above their state's median income, even after monthly expenses on necessities, they may not qualify for Chapter 7. Instead, they'll file Chapter 13 bankruptcy, also known as the wage earner's plan. This form of bankruptcy has the debtor reorganize their finances into a repayment plan that outlines how they'll pay their creditors back over the next three to five years.
While the process for these bankruptcies are very different, the end result is the same. The debtor emerges from the process with a clean slate.
Debt consolidation
Debt consolidation is the process of combining multiple loans into one, Smith says. However, according to Sophie Raseman, head of financial solutions at Brightside, the term encompasses several situations where a borrower replaces one debt with another. Some examples are transferring the balance of one credit card to another, paying off one student loan with another, or paying off credit cards and other consumer debt with installment loans or a secured loan like a Home Equity Line of Credit (HELOC).
Typically borrowers consolidate debt because they can get a lower interest rate or more favorable repayment terms. Smith explains that this is a good option for those with multiple loans who are current on payments and want to optimize their finances. When borrowers consolidate debt, they still pay the full amount of their debt. You can find our guide on the best debt consolidation loans here.
Raseman recommends that before deciding whether or not to consolidate debt, borrowers should ask themselves, "Is this move going to save you significantly on interest costs?" She also recommends that borrowers consider whether consolidating debts is part of a holistic plan for improving payment consistency or getting out of debt, such as by closing credit cards.
It's often not a good idea to consolidate unsecured debt, such as credit cards, by using a secured loan like a HELOC. "Such a move can meaningfully increase the risk you lose your home if your financial situation goes south," Raseman says.
Raseman also cautions that consolidating federal student loans into private loans means losing "generous protections" from the federal government, including relief when some borrowers have financial difficulties and allowing them to reduce payments under some circumstances.
Another factor to consider before consolidating loans is that fees involved in taking out a new loan may offset any savings, says Jay Zigmont, a certified financial planner with Childfree Wealth. It's important to look at the numbers carefully before consolidating a loan.
Debt consolidation vs. bankruptcy
The biggest difference between bankruptcy and debt consolidation is the type of situation that these solutions remedy. Debt consolidations are good for people with a manageable amount of debt across multiple accounts with high interest rates. Their position isn't necessarily bad, but it could be better. On the other hand, bankruptcies are for people in more dire situations. They have an overwhelming amount of debt that they have no hope of paying off.
While a bankruptcy will have a more noticeable impact on your debt than debt consolidation, bankruptcy also come with greater consequences. One of the biggest differences between bankruptcy and debt consolidation is their impact on your credit score.
A good candidate for bankruptcy is not only behind on their payments, but has no way to pay their debts back. As a result, they are probably behind on making payments and have already taken a hit on their credit score. The addition of a bankruptcy will further hurt your credit score. The impact to your credit score will likely be in the triple digits, though the higher your credit score prior to the bankruptcy, the bigger the impact on your credit score. A bankruptcy on your credit report will continue to hurt your credit for up to 10 years.
On the other hand, consolidating debt may affect your credit score positively or negatively, depending on the circumstances. Smith explains that consolidating debts will result in numerous loans being paid and closed and a new loan being generated. While paying off loans may sound like a good thing, it lowers the number of open accounts and overall available credit. This can lower your credit score, Smith explains.
Raseman adds that a hard inquiry on your credit report while you shop around for ways to consolidate loans may also hurt your credit score. "On the other hand, a new loan and payment history may be helpful enough to offset the score difference," Smith explains. Additionally, paying off loans may help your credit utilization ratio, which can help your credit score, Smith says.
However, Smith says it's always a good idea to put a plan in place to deal with debt, even if your credit score takes a hit. "Delinquent debt, when left without a plan of action, can lead to lawsuits, wage garnishment, and more," she says.
Don't expect bankruptcy or debt consolidation to solve all of your financial problems
Neither bankruptcy nor debt consolidation are one-size-fits-all solutions, Smith cautions. "There are still budgeting, spending, and money management issues to work on behind the scenes," he says. The goal after bankruptcy is staying debt-free or at least keeping debt under control.
When it comes to debt consolidation, Zigmont emphasizes that while debt consolidation may feel like progress, the total amount owed does not change. Instead, it gets shuffled around. The goal, he says, should be to pay off debt rather than moving it around. Raseman recommends that after consolidating debts, "it's critical to simultaneously commit to not run up more debt."
Debt consolidation vs bankruptcy frequently asked questions
Is consolidating debt the same as bankruptcy?
A debt consolidation isn't necessarily better than a bankruptcy, but it won't hurt your credit score nearly as much. That said, it will have a smaller impact on the money you save on your debt, only affecting your interest rate.
How much debt can you discharge with bankruptcy?
Bankruptcy should eliminate all your debt, but not all debts are dischargeable. For example, you cannot discharge taxes or child support.
How long will a debt consolidation stay on your credit report?
Debt consolidation isn't a specific piece of information recorded on your credit report, but the hard inquiry that you incur will factor into your credit score for a year and will fall off your credit report after two years.