Debt consolidation and bankruptcy advantages should be weighed carefully
Choosing debt consolidation over filing bankruptcy often comes down to three factors - the effect each option has on a person's credit score, how much the consolidation loan will cost and court protection.
Some financial experts argue that debt consolidation is built into the United States bankruptcy code through Chapter 13, which provides a repayment plan for creditors without any interest charges added to the debts included in it.
When a case is filed in U.S. Bankruptcy Court, creditors are forced to accept the terms decided by the court. Chapter 13 debts are consolidated and prioritized with unsecured creditors at the bottom of the list. That means creditors are likely to get a fraction of what they are owed for the three to five years that the case is active, and any balance on credit cards or medical bills is discharged when the bankruptcy is completed.
The downside of the bankruptcy system's version of debt consolidation is that it will have a negative effect on a debtor's credit rating for seven years.
Developing a debt management plan through a reputable credit counseling agency - which similarly combines all of a person's bills into a single loan – adds the cost of interest. Although only one payment will be required each month, refinancing will cost more because people who seek debt consolidation are classified as credit risks due to the past financial troubles, which places them in a higher interest category.
However, the damage to one's credit rating is significantly reduced and lasts only until an account is fully paid through a consolidation plan.
According to Bankrate, accounts included in a debt management plan are noted on a person's credit report, but do not necessarily damage the FICO credit score. The exception is an instance in which creditors refuse to change the original agreement they have with debtors. As a result, they may continue to calculate a debt based on the established credit rate until it is paid in full.
In most cases, agency counselors act as intermediaries who are able to obtain concessions from creditors that lower the interest rate on debts, sometimes eliminating interest altogether in order to have the principal paid.
Another major difference between consolidation and reorganizing one's debts through bankruptcy is how each option affects a debtor's property. Under Chapter 13, creditor attempts to move forward with foreclosure on a home or repossession of other non-exempt property is halted by an automatic stay that's in place while the case remains open. During the three to five years that the court case lasts, debtors have their homes, cars and personal belongings protected while they catch up on back payments.
Debt consolidation offers no such protection. If debtors find they aren't able to pay their mortgage as well as a large monthly payment on a consolidation loan, creditors can move forward with a foreclosure.
All of these factors can determine whether a debt management plan is more effective in solving long-term financial difficulties than filing bankruptcy.