While some types of debt, such as a mortgage, can help you build financial health, too much debt may lead to significant financial problems. If you're currently struggling to repay your debt, you may wonder if a debt management plan is a good option.
Generally, debt management plans (DMPs) are meant for people who are deeply in debt. While DMPs may help people avoid the major credit impact of defaulting on their debt or declaring bankruptcy, debt management plans can still negatively affect credit scores.
Before you initiate a debt management plan, it's important to understand how the process works, as well as the benefits and drawbacks of this approach to repaying your debt.
How a Debt Management Plan Works
If you're interested in starting a debt management plan, you'll first need to find a credit counselor. The Federal Trade Commission recommends you never agree to any debt management plan until a reputable credit counselor has thoroughly reviewed your financial situation with you. The U.S. Department of Justice maintains a state-by-state list of approved credit counseling agencies, so you can search for someone near you.
Once a credit counselor has reviewed your situation and you both agree that a debt management plan is the next best step, the counselor will negotiate with your creditors to see if they'll agree to reduce interest rates or monthly payments, waive fees or reduce the amount you owe. When your credit counselor reaches an agreement with all creditors, you'll begin making monthly deposits with the credit counseling organization, and it will use the money to pay your unsecured debts.
You'll need to be diligent about paying the agreed-upon amount every month, and credit counselors will typically require you to close your credit cards so that you don't accrue any new debt while working through the debt management plan.
Note that settling your accounts for less than the full amount owed and/or closing your credit card accounts can have a significant negative impact on your credit score. However, many people decide that managing their debt is more important than maintaining their credit scores (or risking the significant credit impact of declaring bankruptcy).
The Benefits of a Debt Management Plan
If you've been having trouble managing debt on your own, a debt management plan can offer benefits, including:
- Consolidation of multiple payments into a single easy-to-remember monthly payment.
- Possible reduction in interest rates, fees and monthly payment amounts.
- An end to stressful collections calls and letters.
- Having a definitive date when you'll be done paying off unsecured debt.
The Downsides of a Debt Management Plan
While repaying your debt more slowly or at a lower interest rate is better than not paying it at all, a debt management plan can still adversely impact credit scores. Although enrollment in a debt management plan isn't a factor in credit scoring models, it can affect other aspects of your credit that are common factors in many credit scoring models.
For example, when you initiate a debt management plan, you may be asked to close credit card accounts. Doing so changes your credit utilization ratio — the comparison between the total amount of credit you have available versus the amount you're actually using. Closing accounts lowers the amount of credit you have available (your credit limit), which increases your credit utilization rate and negatively impacts your credit score.
Additionally, if you negotiate lower monthly payments or settle for less than the full amount owed on any of your accounts, your credit report will reflect that the debt wasn't repaid as initially agreed. This can also harm your credit score.
Finally, if you or the credit counseling agency fail to make payments on time under the debt management plan, those late or missed payments will appear on your credit report. Because your DMP can cover many debts, one late payment to the credit counseling agency may be reflected as a late payment for each account that is part of the DMP on your credit report. A late payment will also harm your credit scores.
Types of Debt that Can Be Included in a DMP
A debt management plan can help you pay off certain types of debt, but not all kinds. Generally, a DMP can include:
- Credit cards
- Some unsecured loans, such as a personal loan
- Collection accounts
Debt management plans cannot include secured debts such as a mortgage, auto loan, or home equity loan; and student loan debt may not be included, either.
How a DMP Affects Your Credit Report and Scores
When you enroll in a debt management plan, that information can be noted on your credit report by a notation. New lenders will know that you weren't able to pay your debts as you originally agreed to do, but are repaying it at a reduced rate- and according to FICO, it won't be considered in your FICO Scores, either.
While that notation appears on your credit report, you will not be able to get new credit. Once the DMP is completed, the notation will be removed from your credit report and will have no lasting effect on your credit.
Completing a DMP can help you improve your credit and credit scores in the long term; however, in the short term it can negatively affect credit scoring in several ways:
- Mandatory closure of credit card accounts will affect your credit utilization ratio, which is a common factor in credit scoring.
- Closing accounts can affect account age. The length of time you've been using credit is also considered by many credit scoring models.
- Closing credit card accounts also reduces the types of credit you use, which is usually explored in credit scoring calculations.
- How the accounts are closed — whether paid in full or settled for less than the full amount owed — can also influence credit scoring.
Important Considerations about DMPs
Debt management plans are usually most beneficial to people who are deeply in debt but who still feel able to avoid the significantly worse impact of bankruptcy. For some, a debt consolidation loan may be a better option. A qualified credit counselor can help you decide if a DMP is right for you.
If you decide to undertake a debt management plan, it's critical that the company or nonprofit managing your plan pays all your debts on time every month. The FTC recommends you take several steps if you decide to enroll in a debt management plan:
- Keep paying your bills until you have written confirmation from creditors that they've approved the plan. Only send a payment to the DMP manager after you've confirmed your creditors are on board with the proposed plan.
- Make sure the organization's payment schedule will pay your creditors before the bill is due each month.
- Call creditors on the first of every month and review your monthly statements to confirm the agency has paid them on time.
- Make sure any concessions — such as lower interest or waived fees — appear on your account statements.