Owing too much debt is painful enough. Being forced into bankruptcy because of the inability to service debts is even worse. Debtors filing for bankruptcy literally have their lives turned upside down. All of their assets are sold off to pay creditors, and they keep only what the court allows. The alternative is debt consolidation. This is much less painful than bankruptcy, but can still be hazardous.
Bankruptcy
Private citizens who do not own or operate a business can file for bankruptcy protection under Chapter 7 or Chapter 13 of Title 11 of the United States Code. Chapter 7 liquidates the debtor’s nonexempt assets and uses the proceeds to repay creditors. The debts that remain after liquidation are discharged by the bankruptcy court handling the debtor’s case. Chapter 13 provides an opportunity for a debtor with regular income to reorganize and restructure his debts. The court helps the debtor create a repayment plan that the debtor must adhere to until all debts are repaid.
The primary advantage of Chapter 7 bankruptcy, which is far more common than Chapter 13, is the elimination of all debts. This gives the debtor a fresh start to use his remaining assets in more profitable ways. The downside is the catastrophic effect bankruptcy has on a debtor’s credit rating. Filing for bankruptcy leaves a black mark on the debtor’s credit report that remains for up to 10 years, depending on the chapter filed. Another disadvantage is a debtor cannot file for bankruptcy again until a number of years pass.
Debt Consolidation
The alternative to bankruptcy is debt consolidation. This is similar to Chapter 13, except there is no damage done to the debtor’s credit rating, and the debtor himself chooses the means to pay off his debts. The process of debt consolidation involves taking out a loan to repay all outstanding debts. The debtor then focuses on repaying the loan as quickly as possible.
Debt consolidation has multiple advantages over bankruptcy. Aside from maintaining the integrity of the debtor’s credit rating, all his monthly payments become consolidated into one single amount. This makes budgeting much easier. If the new payment is less than the combined previous payments, not only does the debtor save money, but he can also pay down his debt faster by paying extra. Finally, the interest rate may be reduced if the debtor negotiates with his new creditor. Combining the various debts into one loan is guaranteed to reduce the interest rate simply because there is no cumulative effect from multiple variable rate debts.
If the debtor does not change their financial habits under this program, a consolidation loan is simply one more invitation to spending and debt. It defeats the entire purpose of taking out the loan. The risk of profligacy dictates using unsecured credit so the debtor’s house or car are not in any danger.
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