Walking away from debt vs. filing bankruptcy

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Walking away from your debt, also known as defaulting, could seem like your best option if you’re struggling to keep up with bills. However, walking away from debt won’t solve all of your problems; the lender can still try to sue you for the remaining amount or sell the loan to a collection agency. If you’d like to wipe the slate clean, bankruptcy could be a viable alternative.

What is the difference between default and bankruptcy?

Defaulting on a loan means that you’ve violated the promissory or cardholder agreement with the lender to make payments on time. Each lender has its own requirements surrounding how many missed payments you can have before it considers you in default. In some cases, that may be as little as one missed payment or it can be as many as nine missed payments.

Filing for bankruptcy, on the other hand, is a legal process that involves listing out your debts and assets and finding a way to resolve the debts. A judge will decide if any of your debts can be discharged and if your assets will be used to pay off the outstanding balance. The judge will also decide which assets you’re allowed to keep and which can be taken from you.

Default and bankruptcy usually go hand in hand. Many borrowers default on their loans and then subsequently file for bankruptcy.

What happens when I default on my loan?

Defaulting on a loan can result in a variety of actions being taken against you as well as other negative consequences. Here are some of the most common outcomes for those who default.

Debt is sold to a collection agency

When you default on a loan, the debt is often sold to a collection agency, which will then try to collect the amount owed.

Lender sues you

A lender can try to sue you in court to garnish your wages or even try to put a lien on your house to collect some of the profits when you sell the home.

Credit score impact

A default will also result in a significant drop in your credit score, ultimately staying on your credit report for seven years. Having a default can make it very difficult to qualify for another loan or credit card.

The type of action taken against you largely depends on whether your debt is secured or unsecured. Secured debt uses your asset as collateral, which can be repossessed if you default. For instance, if you default on an auto loan, the lender will often try to repossess the vehicle.

Unsecured debt, like credit card debt, has no collateral; in these cases, it’s harder for a collection agency to recoup the debt, but the agency may still take you to court and attempt to place a lien on your home or garnish your wages.

What happens when I file for bankruptcy?

Filing for bankruptcy after you’ve defaulted can protect your assets from being seized by the lender or creditor. How it works depends on the type of bankruptcy you file.

Chapter 7

In a Chapter 7 bankruptcy, the court will decide which of your assets to sell in order to repay your creditors. Any remaining debt will be discharged, except for student loans, child support, taxes and alimony. This type of bankruptcy will stay on your credit report for 10 years.

“When you file for Chapter 7 bankruptcy, it’s known as a fresh start. You can discharge all your unsecured debts so that you’re no longer liable for them,” says Katie Ross, executive vice president of the nonprofit American Consumer Credit Counseling.

The court will appoint a trustee who may liquidate or sell some of your possessions to pay your creditors. While most of your debt will be canceled, you might choose to pay some creditors in order to keep a car or home on which the creditor has a lien, says Ross.

Chapter 13

If you file for Chapter 13, you may be able to keep more of your assets while discharging some of your debts. The debt that is not discharged will be put on a three- to five-year repayment plan. This will stay on your credit report for seven years.

“Chapter 13 is about reorganizing financial affairs,” says Michael Sullivan, personal financial consultant with the nonprofit debt counseling company Take Charge America. “A consumer filing for Chapter 13 will have to live on a very strict budget to maximize the payment plan payout to creditors. It works a lot like a debt management plan where there’s a single payment made to a trustee.”

Credit score impact

Your credit score will likely go down significantly if you file for bankruptcy — by at least 130 points but sometimes by as much as 200 points or more. If you work in an industry where employers check your credit as part of the hiring process, it may be more difficult to get a new job or be promoted after bankruptcy.

Jay Fleischman of Money Wise Law says that if you have credit cards, they will almost always be closed as soon as you file for bankruptcy. Getting another loan or credit card will also be very difficult in the early stages after bankruptcy. As time goes on, bankruptcy will affect your score less — if you’re responsible with your credit.

Should I declare bankruptcy or walk away from my debt?

Defaulting on a loan and filing for bankruptcy are not opposite choices. In fact, Fleischman recommends defaulting on a loan before filing for bankruptcy. If you haven’t defaulted, it might indicate that you haven’t given yourself enough time to allow your financial situation to improve.

If you default, filing for bankruptcy can protect your assets from being seized by creditors. It can also protect you from having future wages or an inheritance garnished. “Bankruptcy is useful not only for protecting what you have but also for protecting your future,” Fleischman says.

Other options for dealing with debt

Bankruptcy and defaulting on a loan should not be your first strategies if you have debt. Before you go to those extremes, see if another option for getting out of debt will work for you.

Balance transfer credit card

If you have credit card debt on a card with a high APR, try transferring the balance to a card that offers 0% interest APR. This lets you pay down the balance without being charged any interest.

Most of these special APR offers last between 12 and 20 months, depending on the card’s terms. When the special offer is over, a regular interest rate will kick in, so it’s best to make as many payments as you can during the introductory period.

Using a balance transfer credit card to address debt can both help and hurt your overall credit score. It can help your score by reducing your overall credit utilization rate, which is the amount of your available credit in use. This is important because your credit utilization rate accounts for 30 percent of your credit score.

“If you add more available credit without increasing the total amount of debt you owe, that lowers your credit utilization rate, which increases your credit score,” says Sullivan. “So, if you do a balance transfer and keep the old cards open but do not use them, your credit score will start to improve.”

However, opening a new credit card can also negatively impact your score. When you apply for a credit card, there will be a hard inquiry on your credit report, which can reduce your score. Hard inquiries may stay on your report for as long as two years, though their impact on your credit score will likely decrease before then.

Opening a new credit card can also reduce the average age of the accounts on your credit profile, causing your score to decline. How long you’ve had credit is one of the factors used to calculate your score. A longer credit history is considered better.

Medical debt negotiation

If you have medical debt, you may be able to significantly decrease your monthly payments. Call the billing office, explain your financial situation and try to negotiate a lower monthly payment. Many hospitals offer relief plans and discounts for financial hardship.

“Trying to negotiate lower monthly payments with your provider for your medical debt will not impact your credit score if you pay on time and pay the full amount of debt you owe,” says Ross. “If the monthly payments are lower and easier to manage, there’s less chance that you’ll miss a payment. So, it could indirectly have a positive impact on your credit score.”

Debt consolidation

A debt consolidation loan is a personal loan that you use to pay off other debt, usually from credit cards. Debt consolidation loans typically have low fixed interest rates and terms lasting between one and seven years. Because debt consolidation loans typically have lower interest rates than credit cards, they are a cheaper way to repay high-interest credit card balances.

Debt consolidation loans may cause your credit score to dip initially because of the hard credit inquiry that will be required to apply for the loan.

However, over time this approach to addressing debt may also improve your score if you consistently make on-time payments on the loan. Your payment history is one of the most significant factors in your credit score, accounting for 35 percent of the overall score.

Student loan hardship options

Bankruptcy won’t discharge student loan debt. However, there are options to make your payments more manageable.

Borrowers with federal student loans can choose to pursue deferment or forbearance for up to three years total. Depending on the type of student loans you have and the type of relief you choose, interest may still accrue during this time. Through Sept. 30, 2021, all federally owned student loans are automatically under forbearance with no interest accrual.

Neither deferment or forbearance will impact your credit score, but both will be noted on your credit report.

Another option for federal borrowers is to switch to an income-driven repayment plan with a loan forgiveness option. This will extend your repayment timeline, but because the plan bases your student loan payments on your actual income, your monthly payment may be as low as $0. The good news with this approach is that there is no credit check required to initiate an income-driven repayment plan and it will not impact your credit score.

If you have private student loans, you may still be eligible for deferment or forbearance options. This depends on the lender; if you’re facing financial hardship, call your lender and ask about your options. Deferment programs through private lenders may impact your credit score.

Next steps

If you haven’t defaulted on your loans yet, you still have time to consider other options. Your first step should be to contact all of your lenders and bill providers and explain that you’re struggling with the monthly payments. Seeking out a lower rate, a deferment or a special payment plan may save you from default or bankruptcy in the future.

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