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Home » Investment Banking Tutorials » Corporate Finance Tutorials » Debt Consolidation vs Bankruptcy

Debt Consolidation vs Bankruptcy

By Dheeraj VaidyaDheeraj Vaidya, CFA, FRM

Difference Between Debt Consolidation and Bankruptcy

Bankruptcy can be brought into itself by the debtor or can be forced by the court where debt is honoured anyway of debt restructuring or surrendering of asset while Debt consolidation is a form of refinancing where the entity borrows mostly unsecured family debt to pay off the old outstanding liabilities and consumer debts thus multiple debts are combined into single larger debt with favourable terms.

Bankruptcy is a process where an organization declares that they cannot repay its debt while Debt consolidation is a method of taking out new loans to pay off old debt.

What is Bankruptcy?

Bankruptcy is a legal process where an individual or organization files a petition in court when they are unable to honor its financial obligations or unable to pay their debts. In this legal process, the debtor’s assets are measured and evaluated, and by using the value of these assets the payment is made.

There are two main types of bankruptcy – Chapter 7 and Chapter 13 bankruptcy. Chapter 7 refers to as liquidation bankruptcy and Chapter 13 refers to reorganization bankruptcy.

Bankruptcy-vs-Debt-Consolidation

What is Debt Consolidation?

Debt Consolidation is a process of taking out a new loan in order to repay off the debts. In this process, all multiple debts are combined into a single monthly debt which usually has a newer favorable structure in terms of – lower interest rate structure, lower monthly payment, or tenure. This essentially involves applying for an unsecured loan and use the proceeds to pay off the remaining unsecured debt.

The main aim is to lower the interest rate on the debt you owe allowing the individual to pay less in interest charges and pay more on paying down debt. Unlike bankruptcy, debt consolidation may have a positive effect on the credit score.

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Bankruptcy vs Debt Consolidation Infographics

Let’s see the top differences between bankruptcy vs debt consolidation.

Bankruptcy-vs-Debt-Consolidation-info

Key Differences

  • The bankruptcy process has a very harsh impact on your credit score while using debt consolidation process, you may have a positive effect on your credit score
  • Bankruptcy does not allow the debtor to lower its overall monthly payment. In debt consolidation, the debtor has the advantage of lowering its overall monthly payment.
  • The advantage for people choosing bankruptcy is that they can file for Chapter 7 bankruptcy, where they could reduce some amount of debt or can even dispose of all of their debt amounts. Even though the debtor is allowed to take a new loan to repay its debt amount, but they cannot wipe off their debt completely, as they are still responsible for paying off the new debt amount.
  • According to the chapters of bankruptcy, the length of a process for Chapter 7 is up to six months and in Chapter 13 the process takes about 3 to 5 years. In the debt consolidation process the duration is from several months to years, as it depends on the term of a debt consolidation loan.
  • The tax owed by the debtor is refunded but the money is delayed and when the debts are discharged when the debtor needs to pay tax. There are no consequences of a tax on debt consolidation.

Bankruptcy vs Debt Consolidation Comparative Table

Basis Bankruptcy  Debt Consolidation
Meaning  Bankruptcy is a process where an organization declares that it cannot repay its debt Debt consolidation is a method of taking out new loans to pay off old debt
Complexity Level It is another way to repay your debts but it is a complicated process when compared to debt consolidation. Debt Consolidation is a less complex process to repay your debts.
Credit Score  In the bankruptcy process, you can face a negative effect on your credit score. In the debt consolidation process, you may have a positive effect on your credit score.
Monthly Payment  The debtor is not allowed to lower its overall monthly payment. In debt consolidation, the debtor has the advantage of lowering its overall monthly payment.
Debt Free or Reduction Option The advantage for people choosing bankruptcy is that they can file for Chapter 7 bankruptcy, where they could reduce some amount of debt or can even dispose of all of their debt amounts. Even though the debtor is allowed to take a new loan to repay its debt amount, but they cannot wipe off their debt completely, as they are still responsible for paying off the new debt amount.
Advantages  1. When a bankruptcy is filed, it restricts the credits from repossessing your property.

2. The debtor is not taxed by the Internal Revenue Service on the debt which was exempted in the process of bankruptcy.

3. The debtor can reorganize their debts without giving away their property.

1. The debtor can make one single payment each month to their debt consolidation company.

2. It has flexible options such as lowering your overall monthly payment debt amount.

3. Debt consolidation does not damage the credit score

Disadvantages  1. Bankruptcy is a difficult process.

2.Damages the credit score.

3. It has tax effects involved in this process

1. The full amount owed by the debtor needs to be repaid to the creditor.

2. The creditor can file a lawsuit against debtor even if it is accepting payments or working with the debtor.

3. Interest needs to be paid on the debt amount.

Length of Process According to the chapters of bankruptcy, the length of a process for Chapter 7 is up to six months and in Chapter 13 the process takes about 3 to 5 years. In the debt consolidation process the duration is from several months to years, as it depends on the term of the debt consolidation loan.
Tax Effects The tax owed by the debtor is refunded but the money is delayed and when the debts are discharged when the debtor needs to pay tax. There are no consequences of a tax on debt consolidation.

Conclusion

If you are looking at the restructuring of debt than deciding between debt consolidation and bankruptcy may seem to look like a choice. Bankruptcy allows you to avoid paying the full debt which looks like an easy way out. However, the negative effects should also be considered. Bankruptcy can be opted for if an individual if they can’t make minimum payments every month or if the total unsecured debt is higher than the annual net income.

Debt consolidation may require more money but it makes more sense if you are planning to make major purchases like a new car or home because bankruptcy may damage credit score adversely.

Recommended Articles

This has been a guide to Bankruptcy vs Debt Consolidation. Here we discuss the top differences between bankruptcy and debt consolidation along with infographics and comparison table. You may also have a look at the following articles –

  • Savings vs Investing
  • Z Score Formula
  • Chapter 7 vs Chapter 11
  • Altman Z Score
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