If your debts are keeping you up at night, you might consider some form of debt relief. Debt relief can get you back on your financial feet, but it comes at a price. Here’s what you need to understand to choose a good solution.
What Is Debt Relief?
In general, debt relief is a category of services designed to make debt more affordable or help you get rid of it faster. But a firm that calls itself a debt relief provider is most likely a debt settlement company.
What is debt resolution? Legal debt resolution could involve challenging the legitimacy or collectability of a debt. However, many law firms and debt settlement companies use the term to mean debt settlement services.
Debt relief solutions, from least drastic to most drastic, include:
— Debt consolidation programs
— Debt management plans, or DMPs
— Debt settlement, debt negotiation or debt resolution
— Bankruptcy
When comparing debt relief options, you’ll want to understand their cost, impact on credit scoring, potential savings, success rates and how long they take. You’ll probably want to pick the least drastic option that will get the job done.
[Read: Best Debt Consolidation Loans.]
Debt Consolidation Program
Debt consolidation involves replacing multiple accounts with one loan. Ideally, the new loan has a lower interest rate and payment. Debt consolidation financing can be a balance transfer credit card, home equity loan or line of credit, personal loan, or cash-out mortgage refinance.
— Cost. The cost depends on the loan, but 3% of the loan amount is a fair estimate for balance transfer charges, personal loan origination fees or mortgage closing costs.
— Credit impact. Successful debt consolidation doesn’t usually harm your credit score and can improve it significantly by lowering your credit utilization ratio.
— Savings. What you save depends on how much you reduce your interest rate and repayment time. You may not save anything if you stretch out your loan over many years, but it does lower your payment — and that may be more important to you. Choose the shortest term you can afford to save the most money.
— Success rate. A 2023 TransUnion study found that 42% of consumers who consolidated credit card debt with a personal loan ran their balances back up within 18 months. Personal finance writers commonly say the failure rate is 80% or higher, though data is scarce.
— Timing. Debt consolidation can take six to 24 months with a balance transfer credit card, a few years with a personal loan or 15 to 30 years with a mortgage product.
Pros
Debt consolidation can be an effective way to save money, improve your credit score and repay debts faster — if your credit is good and you avoid excess borrowing in the future. In addition, replacing variable debt like credit cards with fixed loans can make budgeting easier. Debt consolidation can lower your monthly payments by extending repayment, if that’s your priority.
Cons
It’s not easy to qualify for a debt consolidation loan with damaged credit. And installment loan payments can be higher than credit card minimum payments, which are designed to maximize interest income to the issuer. The most damaging con, though, is the resulting debt pile if you run balances back up.
Debt Management Plan
Debt management plans are offered and administered by credit counseling agencies. DMPs are primarily designed for credit card debt, and you probably must close or freeze your accounts when you enroll. (Some plans allow you to keep one card open for emergencies.) You make a monthly payment into the plan, and the agency distributes it among your enrolled creditors. Counselors often negotiate lower interest rates and get late fees and other penalties waived.
— Cost. Plans have monthly charges. One large nonprofit lists its average setup fee at $38 and its monthly fee at $27.
— Credit impact. DMPs can cause a drop in your credit score at first. Closing credit card accounts increases your credit utilization and can also reduce your average account age.
— Savings. This method doesn’t reduce your debt, but you may pay less interest. Data from nonprofit providers suggests average negotiated rates run 6% to 10%.
— Success rate. The average completion rate listed by the Federal Trade Commission is about 50%, with individual providers reporting rates from 35% to nearly 70%.
— Timing. DMPs are designed to clear your enrolled debts within five years.
Pros
Debt management makes paying debt easier by combining several accounts into one payment, and you don’t need good credit to qualify. You may also get a lower interest rate. DMPs can help your credit in the long run if you make your payments on time and clear your balances. Look for a nonprofit provider accredited by the National Foundation for Credit Counseling
if you go that route.
Cons
DMP monthly fees run a few hundred dollars each year, which may make them expensive for smaller debts. DMPs can cause your credit score to drop when you close your credit cards. Because debt management doesn’t reduce the amount owed, it isn’t affordable for everyone, and the process has a fairly high failure rate.
[SEE: Best Debt Settlement Companies]
Debt Settlement
Debt settlement, aka debt relief, debt resolution or debt negotiation, means contacting your creditors and asking them to accept less than the amount you owe as payment in full. This is usually a lump sum but may sometimes be a series of payments. You can hire a debt settlement company or an attorney to help you, or you can do it yourself.
— Cost. Professional debt settlement fees run between 15% and 25% in most states, and forgiven amounts may be taxed as income.
— Credit impact. Missing payments prior to settling causes credit scores to drop dramatically — 100 points or more is not uncommon. And in most cases, you have to skip payments before creditors will settle.
— Savings. Average settlements from debt settlement companies run about 50% before fees and taxes, and customers on average save 32% after fees.
— Success rate. Industry-funded research shows that 74% of debt settlement clients are able to settle one or more accounts within 36 months. Full completion rate according to industry data is about 50%.
— Timing. It takes two to four years for most people to complete their programs.
Pros
Debt settlement can be your best option if you can’t afford debt management or debt consolidation and can’t or don’t want to file bankruptcy. It becomes more compelling if you’re not subject to taxes on forgiven debt. You only settle a debt if you agree with the creditor’s offer and only pay debt settlement fees if you settle. Good credit is not required. Debt settlement is private, so your financial problems are not “out there” for employers or others to see.
Cons
Many debt settlement companies require clients to enroll a minimum amount of debt. Creditors are not obligated to participate, and you might be sued if you stop paying your accounts. Debt settlement can cause significant credit score damage. “Generally speaking, creditors only offer significant settlement savings when a consumer is past due and in default,” says Sierra Izzard, chief operating officer at Pacific Debt Relief. “You rarely see significant principal reductions from creditors when a consumer is current on their payments.”
Amounts forgiven may be taxable. “When settling a debt through debt settlement, you want to make sure you calculate the full out-of-pocket costs,” says Virginia-based debt and bankruptcy lawyer Ashley F. Morgan. “Debt settlement costs are not just what is paid to the creditor, but the fees to the debt settlement company and the tax implications. The tax implications of any settled debt can be even higher if the additional income pushes you into another tax bracket.”
[READ: 5 Best Ways to Consolidate Credit Card Debt]
Bankruptcy
Bankruptcy is the sledgehammer of debt relief. It can be highly effective for tough jobs, but there will be significant collateral damage. The two types of bankruptcy most commonly filed by individuals are Chapter 7 and Chapter 13. With Chapter 7, you surrender assets to the court in exchange for wiping out eligible balances. With Chapter 13, you commit to paying a percentage of your income toward your debts for several years. When you complete your plan, remaining balances are zeroed out.
— Cost. Low-income filers can get fee waivers, and if they do the paperwork themselves, the cost can be zero. But most people pay fees and hire attorneys, and total costs typically run $1,800 to $4,000.
— Credit impact. Bankruptcy can drop your credit score by about 200 points, depending on your starting point, and the filing can remain on your credit report for up to 10 years.
— Savings. The savings depend on your amount of debt, the income or assets you have to give up, and how much you pay for attorney services. Chapter 7 filers may have no assets and discharge all eligible debt. Chapter 13 filers have to give up their discretionary income for several years, with most paying less than 40% of what they owe and about one-fourth paying 70% or more.
— Success rate. Data from Bankruptcy Watch indicates that about 95% of Chapter 7 cases were successfully discharged, and 46% of Chapter 13 filers completed their plans.
— Timing. The U.S. Bankruptcy Court lists 100 days in its Chapter 7 bankruptcy timeline, and many law firms set four to six months as a reasonable time frame. With Chapter 13, you begin making payments within 30 days of filing (there may be adjustments to your plan later), and it takes three to five years of timely payments to complete.
Pros
Bankruptcy can be a cost-effective way to wipe out debt, especially for those who owe large amounts or have few nonexempt assets. Chapter 7 has a high success rate and takes relatively little time to complete. Chapter 13 is more challenging, but it’s possible to finish in three to five years, and most filers pay less than half of what they owe. Amounts discharged in bankruptcy are not taxed as income.
Cons
Bankruptcy takes place in the courts and is public. You have no control over the process once you file. If you don’t agree with what the judge says you must pay or turn over, it can be difficult and costly to walk back your filing. Bankruptcy requires you to pay fees, and most people also hire attorneys. You’ll pay these even if you don’t get your discharge. And with Chapter 7, you have to pay them up front.
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Debt Relief: What Are Your Options? originally appeared on usnews.com
