How to Know if a Debt Management Plan Makes Sense

How to Know if a Debt Management Plan Makes Sense article image.

If you're struggling with overwhelming credit card balances, a debt management plan may be able to help. A debt management plan is a repayment plan where a credit counselor helps you determine how much you can pay toward your debt, negotiates with your creditors and then uses money you provide to pay your creditors until your bills are paid off.

Debt management plans are designed to help consumers get control of their debt without inflicting as much damage to credit as debt settlement or bankruptcy would. These plans aren't for everyone, however, so learn more before signing up for one.

How Do Debt Management Plans Work?

A debt management plan (DMP) is a way for you to pay off your credit card and possibly unsecured personal loan debt by sending a monthly payment to a credit counselor, who distributes the funds to your creditors. Plans typically last three to five years, with the goal of deleting all the debts in the plan. You cannot obtain new debt while participating in a DMP.

To use a debt management plan, you'll need to find a reputable credit counselor. The U.S. Justice Department provides a list of approved credit counselors by state; you can also look to the National Foundation for Credit Counseling for their list of accredited counselors.

In your first meeting with your credit counselor, you'll share your financial goals and review your entire financial picture with them. If you have enough money to put toward debt payment after meeting your essential expenses and setting aside a little for savings, your counselor may offer a DMP. It will include the monthly payment (including a nominal administration fee), the duration of the plan and approximate total interest costs.

Your credit counselor will negotiate with your creditors, who may agree to lower or eliminate fees, reduce interest rates and possibly even reduce the amount you owe. If you agree to the DMP, you will close your credit cards and give the agency permission to manage your accounts. You will send the counselor a single payment each month, and the counselor will pay your creditors. You just need to ensure that enough money is in your checking account on the date the agency withdraws the funds.

If you're having difficulties managing debt on your own, debt management plans offer several advantages:

  • Payment management: Your credit counselor takes over payments so you can focus on other aspects of your life.
  • Single monthly payment: You make a single payment each month instead of several, so handling your finances is simplified.
  • Financial education and support: Credit counseling agencies offer workshops, additional counseling sessions and other resources to help get you back on solid financial footing.
  • Budget help: Your counselor works with you to develop a livable budget that makes room for debt payment and savings.
  • Fewer collection calls: Once your DMP is in place, you should get fewer calls from creditors and collection agencies.

Keep in mind, DMPs are primarily for credit card debt, though sometimes collection accounts and unsecured loans can be included. Secured debts such as mortgage and auto loans, medical and legal bills, and student loans are not included in DMPs. Your credit counselor should provide information on how to best deal with them.

How Does a Debt Management Plan Affect Your Credit?

Enrolling in a debt management plan will not hurt your credit score on its own. Your credit report will note that you are participating in a DMP, but such notes are not calculated into credit scores.

Keep in mind, though, that anyone who pulls your credit report will see it and is free to make a judgment about it.

Actions taken as part of a DMP can hurt your credit scores. Here's how:

Increased credit utilization: As part of your DMP, you'll be required to close the credit card accounts you're paying off under the plan. When you close a credit card, the amount of credit available to you shrinks, which increases your credit utilization rate (the amount of available credit you're using). Credit utilization accounts for 30% of your FICO® Score , so closing accounts can negatively impact your scores.

Diminished account variety: Managing different types of credit accounts is usually good for a credit score, so closing them can shave points from your score.

Possible late payments: The Federal Trade Commission recommends you keep paying your creditors until you receive written confirmation from them noting they have accepted your DMP. Then check with your credit counselor to make sure payments will be made by each account's due date every month, and follow up with creditors to confirm the agency is paying bills on time.

On the other hand, DMPs can elevate your credit scores over the long term. If you had a history of delinquencies, you'll be paying on time, which is positive. Your debt will steadily decline too. Eventually your scores should not just recover, but escalate.

How Is Debt Management Different From Debt Settlement?

Although debt management and debt settlement may sound similar, they are very different. With DMPs, you are satisfying 100% of the amount you owe, while debt settlement allows you to pay less than the full balance. For that reason and more, debt settlement can hurt your credit significantly more than a DMP.

Other ways debt settlement differs from a debt management plan:

  • Debt settlement firms require you to stop making debt payments. The thought is that if you stop making payments, your account will eventually become delinquent. At that point, usually when your account is referred to collections, the creditor will be willing to settle for less than the full amount owed. While you wait out the process, late payments are regularly reported to the credit bureaus, damaging your credit. With a DMP, the goal is to keep your credit in good standing and negotiate terms that will allow you to pay the debt in full.
  • Debt settlement companies have a profit motive. Debt settlement companies are for-profit businesses that usually charge a percentage of the settled debt. For example, if you owe $5,000 and your debt was settled for $3,000, the company may charge you 25% of the $2,000 they saved you—costing you $500. And though you'd be wise not to avoid credit payments as a strategy to reduce debt, these companies can't do anything you can't do for free on your own.
  • You may have to pay taxes on the settled sum. Forgiven debt of $600 or more is considered taxable income by the IRS. The settlement discount, then, may not be as attractive as it initially seemed.

Is a Debt Management Plan Right for You?

A debt management program may make sense if:

  • Most of your debts are unsecured credit card balances.
  • The interest rate reductions are especially favorable.
  • You have a secure income.
  • The payment is feasible for years and doesn't jeopardize your essential expenses.
  • You're ready to make necessary budgetary changes to pay off your debt.
  • You can live a cash-based lifestyle for a number of years.

Alternatives to Debt Management

Even if a DMP is starting to sound like a good decision, weigh it against other potential options:

DIY: Call the credit card companies, explain that you want to concentrate on paying off your debts, and ask if they will reduce the interest rate for you. Some may. Then pay your creditors with the same system: Determine a fixed amount you can send every month, and stop charging. As one account is paid off, pay more to the others until you're debt-free.

Debt consolidation loan: If your credit scores are decent, you may be able to use a consolidation loan. With it you bundle all or most of your debts into one loan that offers a lower interest rate. Even if the lender charges an origination fee of a few percentage points, you may still come out ahead. And if the term is longer than five years, the monthly payment may be far lower than what it would be with a DMP.

Balance transfer credit card: Another way to self-manage debt is to get a low or 0% annual percentage rate (APR) balance transfer credit card. To qualify, your credit scores usually need to be 670 or higher, but the savings can be tremendous. If the APR on a credit card with a balance of $8,000 is 26%, and you delete it in 15 months at zero interest, the accumulated interest you'd save would be $1,456. Use a balance transfer credit card, pay it off within the same time frame, and the only extra charge you'd pay would be a transfer fee (typically 3% of the transferred amount) of $240.

Bankruptcy: Although this should be a very last choice, there may be no other options for some severely indebted people. A Chapter 7 will wipe out all allowable unsecured debts so you can start fresh, but you have to qualify and can lose property. A Chapter 13 lets you pay a wide variety of debts through the court over three to five years. Interest is dischargeable and you get to keep your property, but your spending may have to be pared down. Both bankruptcy types have dramatically bad effects on your credit scores.

Weigh Your Options

So is a DMP the best option for you after all? If your credit history is attractive (check your Experian credit report for free to find out), you need high credit scores now, and you can manage your accounts with a few expense or income adjustments, maybe not. Under the right circumstances it can be, though, and it's definitely worth exploring if you're feeling crushed by credit card debt. At the very least, a nonprofit credit counselor will provide professional financial guidance at no cost to you.