How to Decide Between Credit Counseling and Bankruptcy

Depending on your situation, credit counseling or bankruptcy could be the right choice to eliminate debt. Learn more about your options.

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Medical emergencies, job losses and even divorces can turn a solid financial base into mush, forcing you to make gut-wrenching decisions that come with lasting consequences.

Get to know your options.

Credit counseling, which allows you to design a workout plan with an expert’s help, is one alternative. Bankruptcy is another. If you can’t pay your bills, you need to look at credit counseling and bankruptcy, know the pros and cons of each, then move quickly and choose wisely.

Anyone who files bankruptcy must undergo credit counseling. It’s the law. But counseling can often offer a solution that doesn’t require bankruptcy. A nonprofit credit counselor can help you shape a debt management plan that will restore financial health without having to file for bankruptcy.

Many people who fall into a financial morass don’t see it coming. They might get hit with a huge medical bill or gradually accumulate large unpaid balances on high-interest credit cards. No matter how the crisis occurs, the debtor is unable to pay bills and faces default.

An Ohio State University professor who studies the effectiveness of credit counseling as a remedy for debt, says it is helpful teaching budgeting skills and creating debt management plans that resolve financial problems.

“The choice between a debt management plan and bankruptcy depends on a consumer’s situation, including the amount of debt, the ability to afford payments and longer-term financial goals,” said Stephanie Moulton, who co-authored several studies of nonprofit debt management services. She said those who undergo counseling and enter a debt management plan typically “see higher credit scores about 2.5 years after beginning a plan relative to similar consumers not on a DMP.”

What is Credit Counseling?

Credit counseling offers a pathway to a solution. A nonprofit credit counselor reviews your financial statements, considers you income and helps you decide whether you are a candidate for a debt management program. Approximately 60% of people who go to a nonprofit credit counseling agency discover that a debt management plan will work for them if they commit to at least several years focused on paying off creditors.

Debt management plans aim to lower monthly payments by reducing the interest rate on your credit card. If your income isn’t large enough to resolve your debts in three to five years, the counselor might advise bankruptcy.

It’s important that you know there are other debt relief options. Credit counseling and bankruptcy are two of these options, but you might want to also consider credit card consolidation and debt settlement. The good news is that the purpose of credit counseling is to examine your situation, review all of these options and help you decide which works best.

Pros of Credit Counseling

A nonprofit credit counselor can help you understand what it takes to get out of debt and how to avoid making mistakes that could lead to debt in the future.

Some of the key advantages are:

  • Avoid bankruptcy and its negative consequences.
  • Credit counseling is free, so it doesn’t hurt to learn about your options and hear their advice.
  • Often creates a debt management plan which consolidates bills into a single monthly payment, at a lower interest rate than what you were paying. A plan will usually resolve your debts in three to five years.
  • Helps you learn to make budgets and stick to them. You will learn the difference between good and bad debt, helping you make decisions that will limit your use of credit in the future. Professor Moulton’s research found that debt among those who received counseling declined significantly compared to those who weren’t counseled. Her study suggests that counseling changed the behavior of participants who didn’t manage their money well.
  • Could help you rebuild your rating if it has dropped due to mismanaging borrowing.
  • You might be able to create your own debt management plan after counseling, avoiding administrative fees. To do that, you’ll need to negotiate with your creditors.

Cons of Credit Counseling

Nonprofit credit counseling is free, so there really isn’t much to lose other than a 30-minute time commitment. What you should understand is that they are hoping you qualify for their debt management plan. This plan is a better apples to apples comparison to bankruptcy and has some advantages listed above.

But there are disadvantages too:

  • Many people don’t follow through. A budget and a debt management plan only work, if you stick with them. Yet nearly half those who enter a debt management plan drop out, and only a fraction of those who seek counseling enroll in debt management.
  • During your time in debt management, it might be hard to get credit you can afford to use.
  • It might not work. Credit counselors and debt managers will try to help consolidate debt into a lower-cost monthly payment, but sometimes they fail to get creditors to buy in. If that happens, you may still have high-interest debt to pay directly without the help of the management program.
  • You will still need to pay what you owe on time. If you miss a payment or leave the program, the concessions you received are eliminated and the information will be reported to credit-rating agencies.
  • While another major financial setback may jeopardize your ability to complete the plan, you can always speak with a credit counselor about your changing financial situation and how they might be able to adjust your debt management plan to meet your needs.

What Is Bankruptcy?

Think of bankruptcy as the financial plan of last resort. When your debts are so high that you can’t pay the minimum payment and an affordable debt management plan can’t be configured, bankruptcy might be the only option.

Reaching a bankruptcy settlement takes time. It starts with a credit counseling session to assess your income, debts and assets. It then moves to a federal bankruptcy court where your case is adjudicated. Some states allow you to keep certain assets, your house for instance, but will require you to sell other possessions. It requires that your creditors accept less than they are owed.

Bankruptcy filings rose steeply during the Great Recession but have fallen since. Filing rates showed little change from 2018 to 2019, both years with low unemployment rates. Filing rates ended the century’s second decade as a 10-year low.

Most individuals file bankruptcy under either Chapter 7 or Chapter 13 of the bankruptcy code. Chapter 7 liquidates and distributes all a person’s non-exempt assets and distributes the money to creditors. Chapter 13 allows the petitioner to keep certain assets like homes or cars but requires repayment of other debts. It usually discharges some unsecured debts like those tied to credit card accounts. Some petitioners with high incomes aren’t allowed to file Chapter 7 and must use Chapter 13.

Pros of Declaring Bankruptcy

Bankruptcy can eliminate debts that you can’t afford to pay. Unlike debt management plans, which generally consolidate debt and reduced interest payments, bankruptcy settlements discharge principal. For those with debts too large to manage, eliminating debt might be the only solution.

Here are pluses to consider:

  • Doesn’t require creditor approval. In bankruptcy court, a judge decides how much creditors will receive based on the petitioner’s assets.
  • Chapter 7 clears away all unsecured debt including credit card balances, personal loans and medical bills,
  • The strain of debt is eliminated. Creditors and collection agencies will stop contacting you demanding payment.
  • After your case is resolved you can start rebuilding your credit. You can sometimes qualify for a mortgage two or three years after filing for bankruptcy.

Cons of Declaring Bankruptcy

The consequences of a bankruptcy filing can be long lasting. It can take as long as 10 years for it to be dropped from your credit report, which can make it difficult to borrow money for anything.

Other things to keep in mind:

  • Even if you can get a loan, you will probably pay a high interest rate. It can remain on your report for as long as 10 years, but the effect on you score lessens over time.
  • Potential employers will learn about your bankruptcy and might not offer you a job. You might find it difficult to rent an apartment or house if a landlord pulls your credit report.
  • Though bankruptcy doesn’t carry the stigma it once did, it is still perceived as a negative.

Is Credit Counseling or Bankruptcy Right for You?

Pre-bankruptcy credit counseling is required to file bankruptcy, so no matter which alternative you pick, you will spend at least some time with a counselor. Whether your goal is filing bankruptcy or working out a debt management plan, it’s important to deal with a reputable counselor. Federal bankruptcy courts keep lists of recommended counselors and you should check with the court if you need a reference.

Both credit counseling and bankruptcy have the same objective: To put you on the road to financial health. Each has pluses and minuses. If you can afford to live under a debt management plan and are willing to accept three to five years of austerity, credit counseling and debt management might be the best alternative. If your debts are very large or you are in a hurry to put them behind you, bankruptcy might work better.

About The Author

Max Fay

Max Fay is an entrepreneurial Millennial whose thoughtful writing shows he has a keen eye on both. Max has a genetic predisposition to being tight with his money and free with financial advice. At 25, he not only knows what an “emergency fund” is, he already has one. He wrote high school and college sports for every major newspaper in Florida while working his way through Florida State University. That experience was motivation to find another way to succeed financially and he has at Debt.org. Max can be reached at mfay@debt.org.

Sources:

  1. Roll, S. and Moulton, S. (2016) The Impact of Credit Counseling on Consumer Outcomes: Evidence from a National Demonstration Program. Retrieved from: https://www.fdic.gov/news/conferences/consumersymposium/2016/documents/roll_paper.pdf
  2. NA, (2013, August 13) The Impact of Credit Counseling on Credit Scores. Retrieved from: https://www.experian.com/blogs/ask-experian/the-impact-of-credit-counseling-on-credit-scores/
  3. Schoenherr, N. (2019, July 9) Credit Counseling Can Lead to Significant Reduction in Consumer Debt. Retrieved from: https://source.wustl.edu/2019/07/credit-counseling-can-lead-to-significant-reduction-in-consumer-debt/
  4. NA, (2014, September 2) Difference Between Bankruptcy and Debt Consolidation. Retrieved from: https://www.differencebetween.com/difference-between-bankruptcy-and-vs-debt-consolidation/
  5. Serrano, M. (ND) Debt Consolidation v. Bankruptcy. Retrieved from: https://www.nolo.com/legal-encyclopedia/debt-consolidation-v-bankruptcy.html