Debt Consolidation vs. Chapter 7 Bankruptcy, Part 1: Advantages and Limitations of Debt Consolidation

Bankruptcy is a legitimate solution for the overwhelming debt issues many individuals face, but it’s not right for everyone and other options should at least be considered before turning to bankruptcy as a the answer to debt problems. One of the alternatives that should be considered is a debt consolidation loan.

A debt consolidation loan is a loan taken out to pay off many smaller unsecured debts, such as credit cards, medical bills and past-due utilities. Most people who use a debt consolidation loan properly can save a considerable amount of money and ease the pressure on their finances. This is because the debt consolidation loan replaces many small payments with a single payment that is lower than the combined total of the smaller payments. Additionally, the interest rate on a debt consolidation loan is competitive with the interest rate on most credit cards and other bills, which often results in more of the payment being applied to the principal and the debt is paid off much faster and much less money is spent on interest.

Advantages of a debt consolidation loan:

  • One payment instead of many
  • Lower payment than total of many payments
  • Lower interest rate
  • Pay off principal faster
  • Less money spent on interest
  • Restores credit rating rather than damaging it
  • Transaction is private rather than public record like a bankruptcy
  • Protects reputation and avoids stigma of a bankruptcy
  • Enables debtor to honor obligations rather than discharge debts
  • Debtor may still access credit unless forbidden by terms of the loan

Limitations of a Debt Consolidation Loan

A debt consolidation loan is not for everyone, and such loans have many limitations. The first limitation is that it is itself a debt. If the debtor’s problems stem primarily from a lack of debt-management skills rather than an uncontrollable or unexpected change in income or expenses, then a debt consolidation loan may not be a good idea. This is especially true if the terms of the loan allow the debtor continued use of credit cards or other lines of credit.

Also, a debtor must qualify for a debt consolidation loan. Because it is expected that the debtor will make payments on time each month, the debtor must have regular, reliable income that will meet his or her monthly expenses as well as the consolidation loan payment. In many cases, the debtor will be required to offer up collateral, such as the equity in their house or car, or have a cosigner in case they default on the loan.

When considering a debt consolidation loan, it is important to fully understand the terms of a loan. Some loans include hidden costs or high interest rates that can be more costly in the long term than continuing to pay your bills without the loan. Also, if you are getting an unsecured loan (no collateral involved) at a financial institution with which you already have a secured loan, like a mortgage or car loan, beware of cross-collateralization terms. If you default on a consolidation loan with cross-collateralization, the lender can foreclose/repossess the collateral for the other loan even if you are current on payments for that other loan. You should also be aware that in some instances the money you save with a debt consolidation loan may be considered income by the IRS and you’ll be required to pay taxes on that income.

When bankruptcy may be the better option

In our next article, we’ll continue comparing debt consolidation loans and Chapter 7 bankruptcy and discuss what kind of circumstances may make bankruptcy a more viable option. However, if you have an important debt crisis that needs action now, it’s advisable that you contact an attorney with expertise in bankruptcy and debt management. Maryland bankruptcy lawyer John Burns and his firm can assist in identifying a workable and advantageous solution to your debt issues and help you take action toward a resolution. Call our office at 301-441-8780 to schedule an appointment or e-mail us at jburns@burnsbankruptcyfirm.com.