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Debt relief works by giving you a path toward getting rid of your debt. Depending on your current debt situation, there are several types of debt relief that can help you achieve your goal.
However, it's important to understand both the benefits and the drawbacks of debt relief and how it can affect your credit.
What Are the Types of Debt Relief?
There are four types of debt relief that borrowers can use to work toward becoming debt-free. Depending on the severity of your financial situation and your ability to repay what you owe, one method may be better than the others. Here's a quick summary of each and when you might consider them.
Debt consolidation is the simplest form of debt relief, and you can accomplish it on your own. You can consolidate your debt by applying for a new loan or credit card and using it to pay off existing debts.
This strategy works best if you can qualify for a loan or credit card that offers a lower interest rate than what you're currently paying—that typically requires good or excellent credit, which means a FICO® Score* of 670 or higher.
Some balance transfer credit cards offer introductory 0% annual percentage rate (APR) promotions that allow you to pay down your debt interest-free over a period of a year or more. This is an excellent strategy as long as you can pay off the transferred debt before the promotional period ends; otherwise, you'll owe interest on the remaining balance.
If you're trying to pay off high-interest debt with a loan, you could choose a personal consolidation loan or, if you own your home, a home equity loan or home equity line of credit. Just keep in mind that if you use your home as collateral for a loan, you risk losing it if you can't keep up with loan payments.
Debt consolidation is best for borrowers who have a manageable amount of debt and have a relatively high credit score, which is necessary to qualify for favorable rates on a consolidation loan or credit card.
If you're having trouble making your monthly payments and your credit is less than perfect, working with a credit counseling agency could be a good next step.
Credit counselors can not only help you with basic things like creating a budget, but they can also put you on what's called a debt management plan. With this arrangement, you make just one monthly payment to the credit counseling agency for all your unsecured debt obligations, such as credit cards and personal loans. The agency then uses that amount to make payments to your creditors on your behalf.
Credit counseling agencies can negotiate lower interest rates with creditors, so you may end up saving money with this option. However, you may be required to close your credit card accounts, and you can't apply for new credit until you complete the debt management plan, which can take years.
If you're considering a debt management plan, make sure you're working with a nonprofit credit counseling agency, which can offer lower costs. You can find a nonprofit agency in your area through the National Foundation for Credit Counseling or the Financial Counseling Association of America.
Debt settlement companies negotiate with your creditors to settle your unsecured debt for less than what you currently owe. Instead of creating a modified repayment plan like a credit counseling agency does, for-profit debt settlement companies encourage you to stop making payments on your debts and instead make payments into an account with the company.
As soon as your balance with the debt settlement company is high enough—the amount can depend on the company and type of debt—it will use the cash to negotiate with your creditors to settle for less than the current principal and interest amount.
Because debt settlement encourages you to stop making payments on your loans and credit cards for an indefinite period of time—and could cost you hundreds or even thousands of dollars in fees—it's not a recommended debt relief strategy.
If your debt situation is so dire that you can't even afford to make modified monthly payments on a debt management plan, bankruptcy may be the last resort option. A bankruptcy will do serious damage to your credit and will factor into your credit score for up to 10 years, which is why you should only consider it if you've exhausted your other options.
There are two types of consumer bankruptcy, including Chapter 7 and Chapter 13:
- Chapter 7: With this option, most of your assets are sold to pay off whatever you can, then the remainder of your debt is wiped out. It's designed for people with low incomes who can't afford a restructured debt repayment plan.
- Chapter 13: With this type of bankruptcy, your debt repayment plan is reorganized to make it affordable for you, and you must complete the new court-mandated repayment plan. The remaining balances left over at the end of the restructured repayment plan—which typically takes three to five years—are discharged.
One thing to keep in mind is that, like debt management plans and debt settlement agreements, filing bankruptcy typically won't get rid of your mortgage, auto or student loans.
How Debt Relief May Help You
Depending on the type of debt relief you choose, there are many potential advantages of using these methods to become debt-free:
- With debt consolidation and a debt management plan, for instance, you could potentially get a lower interest rate, which can save you money on interest charges and also allow you to pay off your debt sooner because of the lower overall cost.
- Bankruptcy can also potentially get you out of debt without requiring you to pay the full amount of what you owe. And with Chapter 7 bankruptcy, you could even start rebuilding your credit history and financial life with a clean slate free of debt within just a few months.
Depending on your situation, the actual results of debt relief can vary. But they may be better than the circumstances you currently find yourself in.
What Are the Risks Associated With Debt Relief?
While there are some significant benefits of using certain debt relief methods to eliminate your debt, there are some potentially major drawbacks that may cause you to rethink your options:
- If you choose debt consolidation, some consolidation loans charge origination fees and most balance transfer credit cards charge balance transfer fees. These fees can limit the value of consolidation, though you can still save hundreds of dollars on interest despite them.
- There is no guarantee that your interest rate will be lower with debt consolidation or a debt management plan.
- There's no guarantee that a debt settlement company can negotiate a lower payment with your creditors. And even if it does, the process is likely to severely damage your credit.
- Credit counseling agencies and debt settlement companies typically charge fees for their services. While credit counseling agencies are typically much less expensive—a small upfront fee and an average of roughly $30 per month versus 15% to 25% of the settled amount with debt settlement firms—it's still a charge you'll need to consider with your plans.
- With debt settlement, the difference between what you owe and what you settle for may be considered taxable income. You may also open yourself up to lawsuits from your creditors because you've stopped making payments.
- Scammers may use the hope of debt relief through counseling and debt settlement to take advantage of you.
As you consider whether debt relief is right for you, consider how these potential drawbacks could affect you. In some cases, they may be better than the current situation, but they could also make things worse.
How Debt Relief Can Affect My Credit Score
Depending on which debt relief method you choose, it could have a minimal or significant impact on your credit score.
For example, with debt consolidation, applying for a new loan or credit card could have a small negative effect on your credit score. Also, if moving a balance from one credit card to another increases your credit utilization rate—the percentage of the card's credit limit you're using—it could drop your credit score more significantly until you can pay down the balance.
With credit counseling, you typically won't see any major negative effects with your credit score, because you're still paying your debts as agreed. However, closing your credit card accounts could affect your credit utilization rate and eventually shorten the length of your credit history.
Because your payment history is the most important factor in your FICO® Score, the credit score most often used by lenders, your credit can suffer considerably with debt settlement and bankruptcy. With debt settlement, you're encouraged to stop making payments, so delinquencies and collection accounts can add up quickly, and those negative items will remain on your credit report for seven years.
A bankruptcy will also cause a significant drop in your credit score and will be part of your credit score calculation for up to 10 years.
How to Choose the Right Debt Relief Option for You
The right debt relief method for you depends on your financial situation and the level of risk you're willing to take to get rid of your debt.
In general, it's best to try to get on a budget and consolidate your debt first. You may even be able to do some negotiating with your creditors on your own to get on a modified repayment plan or qualify for a lower interest rate.
If your credit isn't in good enough shape to consolidate your debt, consider working with a credit counselor to get on a debt management plan. The drawbacks of this option—a monthly fee, closed credit card accounts and no new debt—aren't ideal, but they're reasonable.
If you're considering more dire measures, including debt settlement and bankruptcy, carefully consider all of the potential risks and whether you can manage with another approach. If you can't, consider the costs associated with each option and the potential impact on your credit scores before you move forward.
Consider Both Short- and Long-Term Effects
Getting out of debt sooner than later is always appealing, but depending on the potential negative long-term impact, it may not be worth it. As you consider which debt relief approach to use, think about the trade-offs for each one. Also, checking your FICO® Score can help you understand whether debt consolidation, the mildest of the four approaches, is an option.
If you're having trouble figuring out the best path forward, consider reaching out to a credit counseling agency to get some basic advice based on your situation. While they can help with a debt management plan, they can also tell you whether one of the other debt relief methods would be a better fit.