Key takeaways
- Using a debt consolidation loan to combine your existing debt can help you streamline your monthly payments and save on interest.
- Other debt relief strategies like debt settlement and bankruptcy should only be used as a last resort since they can cause serious harm to your credit profile.
- A credit counselor can create a debt management plan for you (DMP) — this plan can help you pay off debt within two to five years.
Have you tried different approaches to pay down your debt but aren’t having much luck? Or maybe your monthly debt payments are too much for your budget. Either way, you’ve likely considered researching debt relief options to get your finances back on track.
There are several methods to choose from, but not all may be ideal for your finances. Some could have adverse financial consequences that could be challenging to overcome.
How debt relief works
How it works varies depending on the type of debt relief you choose but usually involves negotiating with a creditor to lower your interest rate, decrease your monthly payments or pay less than what you owe. You can negotiate with a creditor directly or hire a debt relief or settlement company.
When you should seek debt relief
If you’re having trouble repaying your loans, consider contacting your creditor first to see what type of relief it offers. For example, if a lender offers forbearance or deferment, which temporarily suspends your monthly payments, you may be able to avoid damaging your credit. After you’ve contacted the lender, explore other options if it’s unable to provide you with a solution.
Why debt relief services can damage your finances
Unfortunately, debt relief services can often mean bad news for your finances. Some consumers enter into debt relief programs that they cannot finish or fall victim to the tactics of scammers. Either way, you could find yourself in an even deeper debt hole. Some debt relief programs can also damage your credit scores – particularly those that suggest you stop paying while enrolled or only pay a fraction of what’s owed to settle the outstanding balance.
Types of debt relief
Not all forms of debt relief are ideal for every consumer. It depends on your current debt load, credit rating, interest rates and financial situation. Whether you should work with a specific debt relief company also depends on how involved you want to be with the process.
Debt consolidation
Debt consolidation involves merging several accounts into one to streamline the repayment process, save on interest and possibly pay off your debt sooner. This approach can work if you have good or excellent credit and can qualify for a debt consolidation loan or balance transfer credit card.
Ideally, the debt consolidation loan will have a better interest rate than what you’re currently paying on all your debts. If you choose to use a balance transfer card, it’s best to pay off the amount you transfer within the promotional APR period. It typically lasts between six and 21 months, and the remaining balance will begin to accrue interest at the card’s variable rate after that timeframe.
Debt settlement
You can negotiate with creditors to settle debts or hire a company to do it for you. If you choose the latter, the debt settlement company will ask that you make a set monthly payment to a dedicated account. These funds will pay creditors and cover their fees as settlement offers are reached.
In the meantime, some debt settlement companies will also advise you to stop making the minimum monthly payments to creditors to speed up the process. In turn, your credit score will hit as the missed payments appear on your credit report. Still, there are no guarantees that your creditors will accept settlement offers, whether you negotiate on your own or a debt settlement company handles the negotiations.
Your credit score will be negatively impacted as accounts are settled since they’ll reflect on your credit report as “partially paid” instead of “paid in full.” With that being said, this approach can be risky for your finances.
Debt forgiveness
Some creditors and lenders offer debt forgiveness options for borrowers facing financial hardship. You may be eligible to have all or a portion of your balance forgiven on your student loan, credit card or mortgage. When you enter into a settlement agreement, it also constitutes debt forgiveness on the portion of the balance that the lender will not collect.
Debt forgiveness may sound appealing, but it can also have dire consequences. Your credit health could take a hit, and you may get a tax bill if the amount forgiven is subject to taxation.
Credit counseling
Credit counseling is available through non-profit agencies, often free of charge or at a low cost. You will meet with a credit counselor to review your finances. During the meeting, they will also work with you to create a plan to better manage your income, expenses and debt load. They may also suggest other alternatives, like a debt management plan, to get a handle on your outstanding debt.
Debt management plan
A debt management plan (DMP) is a three- to five-year roadmap designed to help you get out of debt sooner. You’ll repay the total amount you owe, but the credit counselor will work with your creditors to negotiate concessions, including fee waivers or reduced interest rates.
If the creditors agree to the plan, you’ll begin making the monthly payment specified in the DMP to the credit counseling agency. They will divide this amount amongst creditors each month per the payment schedule in the agreement. You should also know that the creditors will most likely close your accounts when you enroll in a DMP. Furthermore, you probably won’t be allowed to apply for new credit until the plan is complete.
Bankruptcy
Bankruptcy is a type of debt relief that should only be used as a last resort. The two most common forms of bankruptcy are Chapter 7 (liquidation) and Chapter 13 (reorganization).
Chapter 7 often requires debtors to liquidate personal property to repay creditors. You won’t have to give up your assets under Chapter 13, but you’ll enter into a payment plan that lasts three to five years before your debts under the bankruptcy filing can be discharged.
Be sure to consult with a bankruptcy attorney before filing. Both will have severe consequences for your credit. Chapter 7 lingers on your credit report for up to 10 years, and Chapter 13 stays for up to 7 years following the filing date.
Common debt relief scams
Fraudsters know that consumers seeking debt relief may be desperate to find the help they need. So, they prey on the vulnerability of those who need assistance with scams that could cause even more damage to their financial health.
As you’re researching companies that provide debt relief services, steer clear of those who demand upfront payment or make promises about debt settlement offers. It’s also a red flag if the company:
- Tells you to cease all forms of communication with your creditors and lenders
- Promises to make your unsecured debt disappear or help you pay it off for pennies on the dollar
- Suggests that you use a “new government program” to eliminate your credit card debt balances
You can also avoid scams by checking the company’s accreditation status with the National Foundation for Credit Counseling and the Better Business Bureau. Both platforms allow consumers to read complaints they’ve received (if applicable). And be sure to visit your state attorney’s office and search for the company to confirm they’re licensed to operate in your state.
What not to do when you pursue debt relief
If you decide to move forward with debt relief, weigh the benefits and drawbacks of each option to make an informed decision. Even if you’re overwhelmed with constant calls and letters from collection agencies, do your research to minimize your chances of entering into an arrangement with a debt collector or creditor that doesn’t work for your finances or falling victim to a scam.
Another word of caution: avoid prioritizing unsecured debts over secured debts. Unsecured debts, like credit cards, personal loans and medical bills, aren’t backed by collateral. However, secured debts, like car loans and mortgages, are, which means you could lose your assets if you fall behind on the payments.
You also want to avoid taking out a home equity loan or home equity line of credit (HELOC) to pay unsecured debts. These debt products use your home as collateral, putting it at risk of foreclosure if you default on the loan.
Borrowing against or withdrawing funds from your nest egg also isn’t a smart financial move when looking to pay off debt. The more money you pull from your retirement savings, the more you’ll miss out on the opportunity to let compounding interest work in your favor. If you borrow funds from your 401(k) and lose or leave your job, the loan will become a withdrawal, and you could owe taxes on the balance.
Bottom line
If you’re drowning in debt, there are debt relief options available that can assist. But not all offer the same benefits or are suitable for your long-term financial health, and you could damage your credit rating or end up worse off than where you started. So, it’s vital to understand how each debt relief option works and weigh the benefits and drawbacks before selecting the best strategy for your financial situation.
