Bankruptcy vs. Debt Consolidation: Which is Better?
The federal government requires all potential filers to go through credit counseling before declaring bankruptcy. The purpose of credit counseling is to determine if there are other ways you can resolve your financial problems besides filing under Chapter 7 or Chapter 13. One of the common alternatives frequently compared against bankruptcy is called “debt consolidation.” How are these two options different? Which one is better? Our Harrisburg bankruptcy attorneys at Young, Marr & Associates explain the pros and cons.
How Does Debt Consolidation Work?
Before we can compare bankruptcy against debt consolidation, we need to go over what debt consolidation is and how it works.
Debt consolidation is the process of merging multiple debts into a single, more comfortable to manage debt. The general idea is debtors will find it easier to handle one debt than balancing numerous payments, which are all on different schedules and are being paid out to different creditors.
Consolidating debt has two objectives: simplifying repayment processes for debtors, while simultaneously reducing monthly payments and interest rates. Essentially, you would be taking out a new loan in order to pay off the debts you have already incurred.
Do not confuse Debt consolidation with debt settlement, which is paying creditors with a lump sum payment, which is lower than the total amount you actually owe. There are several ways to negotiate with your creditors to settle a debt. If you qualify, a credit counselor from an approved credit counseling agency will negotiate with the creditors for you. In other situations, a person will hire a debt settlement company for a fee, usually based on the percentage of debt owed, to work directly with their creditors. In a few cases, a person could choose to negotiate with their creditors on their own. An important thing to remember about any debt settlement is that any amount you are not required to pay back will be considered “income” for federal income tax purposes.
A simple way of differentiating settlement from consolidation is to remember that settlement focuses on reducing your debts, while consolidation focuses on reducing your creditors.
Bankruptcy follows a different process from debt settlement or debt consolidation. In Chapter 7, the trustee assigned to your case (or a third party whom the trustee has hired) sells your non-exempt property to creditors to help pay off your debts, while you keep your exempt property. In Chapter 13, you, your attorney, will propose a repayment plan or “reorganization,” adhering to the provisions in the Bankruptcy Code, to gradually pay off a certain portion of your debts.
Both Chapter 13 and Chapter 7 discharge most debts, including medical bills and credit card debt, which means the debtor is no longer liable for paying the debt. Our guide to filing for bankruptcy in Pennsylvania explores the process in greater depth.
Pros and Cons: Filing for Bankruptcy vs. Consolidating Your Debts
There are several pros and cons to filing for bankruptcy and debt consolidation, and the “right” choice depends on your financial goals. You should always consult with an experienced attorney, who can help you make the right decision for you.
One key reason most people choose bankruptcy is for protection against all creditors. From the moment you file, you are protected by something called “the automatic stay,” which will remain in effect throughout your case unless your creditors succeed in lifting the stay. The automatic stay puts a temporary freeze on all collection actions against you, including foreclosure, repossession, and utilities being shut off for nonpayment. Debt consolidation is not subject to the automatic stay.
An automatic stay is a federal court injunction that goes into effect the moment your bankruptcy petition is filed. It prohibits all collection actions against you, such as phone calls and collection letters. More importantly, it stops your creditors from utilizing lower courts to pursue collection through legal actions. An automatic stay will halt all lower court proceedings, including collection lawsuits, foreclosure actions, and scheduled sheriff sales. Additionally, filing for bankruptcy will prevent a vehicle repossession or a utility shut-off. Depending on your filing’s timing, your lender could be forced to return a repossessed car. If a utility service was terminated, filing for bankruptcy is a way to have it restored. Do not hesitate to call our bankruptcy attorney if your car was taken.
The importance of an automatic stay cannot be understated. It allows you to address your financial situation through the federal courts without having to worry about your creditors taking other actions against you. In situations where a creditor violates the stay, our bankruptcy attorney could petition the court for monetary sanctions. This protection is not available through debt consolidation or debt settlement.
Bankruptcy Provides a Fresh Start
The other main advantage of filing for bankruptcy is that it wipes the slate completely clean. Not only is the financial burden lifted when your debts are discharged — so is the heavy psychological burden that comes from months, years, or even decades of sleepless nights worrying about how to make ends meet. With most of your significant debt sources eliminated, you can start clean again by keeping up timely payments on your loans. By staying on top of your finances, you can quickly begin to rebuild healthy credit.
Debt consolidation does impact your credit score to the same degree as filing for bankruptcy. If you are frequently behind on your bills, which is true of many people considering Chapter 7 or Chapter 13, your credit is already severely damaged. Bankruptcy gives you the ability to start improving the situation by removing many of your financial obligations. Additionally, if you combine all your debt into one loan, it might take a considerable amount of time to complete your payments. A bankruptcy, even a Chapter 13, is typically a much faster process. This allows you to begin building good credit quicker and move on with your life.
Debt consolidation can also be harmful when it comes time to file taxes. The IRS may determine that the money you saved by opting for consolidation is actually considered income, which means you will be required to pay tax on that income. In other words, the money you save now may be lost to taxes later. (Note that settled debts are also classified as income and are therefore subject to tax.) Any debt that is eliminated through filing for bankruptcy does not have any tax consequences.
Eliminating All or a Portion of Your Debt
When someone is considering filing for bankruptcy or consolidating their debt, they are looking for a way out of the financial crush they are experiencing. Often, the benefit of debt consolidation is lowering the interest you must pay on several loans and bills. By gathering all your debt into one payment schedule, you can save some of those additional fees and charges. On the other hand, filing for bankruptcy allows you to eliminate your debt almost immediately or pay a substantially less amount than you owe.
In Chapter 7, a debtor can discharge the vast majority of their debt, including credit card bills, medical debt, and personal loans. While people do fear losing their home or having to sell their property when filing for Chapter 7, the Bankruptcy Code provides numerous exemptions or ways to protect your property. Very few debtors are required to surrender their personal assets. Our knowledgeable bankruptcy attorney will review your property, debts, and income to determine if you qualify for Chapter 7.
A debtor who files Chapter 13 is required to make a monthly payment to their creditors for three to five years. Often, someone who qualifies for Chapter 7 will file a Chapter 13 because they have property they could not protect. One important thing to understand about a bankruptcy payment plan is that it is not a negotiation. What you must pay is determined by the Bankruptcy Code, the type of debt, your income, and your non-exempt property. For example, if you have $45,000 of debt and $10,000 in non-exempt property, you will have to pay $10,000 to your creditors. The remaining $35,000 would be discharged. However, this is a simple illustration. Each bankruptcy filing is unique, offering its own challenges. Therefore, it is essential to review your situation with our experienced bankruptcy attorney.
Keeping Your Home or Car
Consolidating your debt is sometimes an excellent way to handle a couple of outstanding credit card bills – especially if the total is not that significant and the interest rate is astronomical. However, there are situations where consolidating your debt will not help you. The most common examples of this are home foreclosures or vehicle repossessions. As stated above, filing for bankruptcy will stop a foreclosure and a repossession. However, bankruptcy also provides a debtor the means to keep their home or car.
Once you have fallen behind on your mortgage payments, your lender will file a foreclosure complaint to take possession or sell your house through a sheriff sale. By filing for bankruptcy, you not only stop the foreclosure, but you also force your lender to accept a five-year payment plan to pay back the money you are behind. A bankruptcy works the same way with a repossessed vehicle. Not only does bankruptcy stop the repossession, it allows you the full length of your bankruptcy to pay your delinquency. In some cases, you might be able to lower your total car payment to the fair market value of your vehicle. Our bankruptcy attorney will thoroughly review your car loan and assist you in trying to keep your car.
What About Attorney Fees?
At Young, Marr & Associates, we understand that cost is an important consideration when making your decision. There are attorney fees associated with filing for bankruptcy. However, these fees are substantially less than the total financial benefits of filing for bankruptcy. If you qualify for Chapter 7 and can eliminate $65,000 worth of personal loans, medical bills, and credit card debt, it is much less expensive than having to pay your creditors in full. While Chapter 13 will require you to pay a portion of your debt, it is often less than what you owe. If you are required to pay your creditors in full, the amount you pay is what you owed on the date you filed for bankruptcy. There is no interest paid on the debt. This usually offsets any attorney fees. Additionally, any consolidation loan will still have fees and interest to consider.
Call Our Experienced Philadelphia Bankruptcy Attorney to Schedule a Free Consultation
The choice can be difficult, but we are here to assist. If you’re struggling to manage your debt and are thinking about filing for Chapter 13 or Chapter 7, our experienced Easton bankruptcy lawyers can help. To set up an evaluation with a bankruptcy lawyer, call the law offices of Young, Marr & Associates at (609) 755-3115 in New Jersey or (215) 701-6519 in Pennsylvania today.