When you're overwhelmed with debt, you may feel like bankruptcy is your only option. Bankruptcy is a legal process that can release you from certain debts, and it can provide a fresh start for people who feel they are drowning. But bankruptcy has severe and lasting consequences on your credit, impacting your ability to borrow for as long as 10 years. It's also a costly and stressful process, and it can result in forfeiting assets such as your home or car.
Because of its lasting harm to your credit and finances, bankruptcy should be considered a last resort. Read on for seven steps to take before you consider bankruptcy.
1. Take Inventory of Your Debt
Your first order of business to avoid bankruptcy is to get a clear understanding of exactly what you owe. Start by writing out all your debts. For each debt you owe, list the following:
- Total balance
- Interest rate
- Minimum monthly payment
- Monthly due date
Seeing your debt laid out in front of you can be overwhelming, especially when you feel swallowed by it. But creating a clear list of what you owe is an important first step in deciding what to do next.
2. Create a Bare-Bones Budget
When you're trying to avoid bankruptcy, you'll need to get very strict about your spending. The goal is to meet your basic expenses while slashing any nonessential spending. While this is challenging, it's key to regaining financial control and freeing up funds to funnel toward your debt.
In addition to cutting out discretionary spending such as retail, dining out, cable, subscriptions and the like, investigate ways to lower your basic expenses. That may mean spending less on groceries, negotiating your bills, considering cheaper housing and even selling a car, if you have other transportation options. Some of these options may feel extreme, but depending on your situation, they may be called for.
3. Seek Additional Income
Consider supplementing your income and directing the cash you earn toward your debts. You'll need to do the math to determine how much extra money you'd need to bring in per month in order to afford all your minimum payments and, ideally, aggressive payments on your highest-interest debts.
Consider these ideas for increasing your income to pay off debt:
- Take on an additional part-time job. If you have the time available, look for a part-time job that you can fit around your current schedule. You can also ask your current employer if you can take on extra shifts or work overtime.
- Do gig work. Consider a gig that fits your interests and experience. Driving for a ride-hailing service, pet sitting, babysitting and tutoring are all gigs with high demand that you can fit around your current job.
- Sell things online. If you have items you won't miss, consider selling them through a local online marketplace.
4. Try a Debt Payoff Strategy
If you're currently able to afford your minimum payments but aren't sure how to tackle debt, consider one of these strategies:
- The snowball method is a debt repayment strategy that has you pay off your debts starting with the smallest balance first. Seeing the number of balances dwindle can help you gain motivation and keep overcoming your debt.
- The avalanche method has you pay off your highest-interest balance first. This strategy has the huge benefit of decreasing the overall cost of your debt by saving you the most money in interest.
Whichever strategy you use, be sure to continue paying the minimum on each of your debts while you apply additional funds strategically.
5. Consolidate Your Balances
If you've been making on-time debt payments, you may be able to qualify for a debt consolidation loan. Consolidating your debts can make repayment cheaper and easier to manage.
Debt consolidation is the process of folding multiple balances into one loan. Rather than making payments on multiple credit card balances and loans each month, you'll make one payment on a new loan, ideally with a lower interest rate. This can lower your monthly payments, making repayment more sustainable.
There are also downsides to debt consolidation to consider. First, if you're currently carrying high balances or have missed payments, qualifying for a new loan with good terms may not be an option. Learn more about how to qualify for a debt consolidation loan and check your credit to see where you stand.
Second, consolidating debts can provide relief from the immediate burden of multiple high balances due. When that happens, you may be tempted to use the credit you free up to spend more money. That can lead you further into debt.
6. Seek Credit Counseling
Meet with a certified credit counselor to discuss your situation before you consider bankruptcy. Credit counseling is a service that helps people chart a course out of debt.
A certified credit counselor from a reputable agency will meet with you for a free initial consultation in which they'll review your finances with you. They'll also share resources on budgeting and debt repayment.
Your credit counselor will help you come up with a plan based on your individual financial situation and the severity of your debt. In some cases, a credit counselor will recommend that you enroll in a debt management plan (DMP). With a DMP, you make one monthly payment to your credit counseling agency, and the counseling agency uses those funds to pay off your debts.
The benefits of a DMP include having a set plan for repayment and possibly lower interest rates and balances negotiated by the credit counselor. However, there are drawbacks to enrolling in a DMP, too, including fees and decreased access to credit.
7. Understand Debt Settlement
Debt settlement companies, which may call themselves "debt relief" companies, are for-profit businesses that say they will negotiate with your creditors to lower what you owe. The settlement company's goal is to gain leverage with your creditors by encouraging you to cease payments and then offering to make reduced payments on your behalf. However, there are major risks to debt settlement.
If you stop making minimum payments, you'll see serious damage to your credit and you'll likely be charged high penalty fees and interest on your balances each month. This can put you even further in debt. Debt settlement companies also often charge high fees and they may not be able to settle all your debt. In addition to these lasting consequences of debt settlement, you can also expect your creditors to ramp up their collection efforts, and it could even result in a debt collection lawsuit against you.
For these reasons, you're far better off consulting a nonprofit credit counseling agency rather than a debt settlement company.
Bankruptcy Is a Last Resort
Talk to a nonprofit credit counselor about your options for managing your debt and ensure you've exhausted other relief options before you consider bankruptcy. In addition, take action to protect and rebuild your credit over time. To see where you stand now, check your credit report for free through Experian.
