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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 explain the pros and cons.

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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.

As the name suggests, debt consolidation involves lumping multiple debts together into a single, more manageable debt. The general idea is that most debtors have an easier time handling one debt than trying to balance numerous payments which are all on different schedules and are paid to different creditors.

Debt consolidation has two objectives: to simplify the repayment process 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.

Debt consolidation should not be confused with debt settlement, which involves paying your creditors a lump sum payment which is lower than the total amount you actually owe.  In debt settlement, a credit counselor from an approved credit counseling agency will negotiate with creditors for you.

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, and your creditors will negotiate a repayment plan or “reorganization” 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.

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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 that it offers considerable protection against 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.

The other main advantage of 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 not make as strong of an impact upon your credit score as filing for bankruptcy.  But remember, while bankruptcy initially hurts your credit, it also gives you a base to start improving your credit.  If you are constantly behind on your bills, which is true of many people who are 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.

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.)

The choice can be difficult, but we’re 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 you weigh your legal options and evaluate the financial outcomes.

To set up a free and confidential case 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.

Have You:

Been paying credit card balances that seem to never go down?

Lost your job and are now having trouble keeping up?

Attempted to work out a payment arrangement to no avail?

Been notified of a mortgage foreclosure action?

Been denied for a mortgage or other line of credit?

If the answer to any of these questions is “yes” then bankruptcy may be an option that you should consider.

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