Debt is common as people increasingly use credit cards or loans to cover various types of expenses. Although credit can be convenient and helpful in many cases, it can quickly get out of control. According to the Municipal InstituteThe average amount of debt in collections – meaning the debt has been sold to a collection agency and can incur costly fees – is $1,739 per borrower.
If you’re struggling with high balances and interest rates, there are several ways to pay off your debt faster and save money. Three common strategies are debt management plans, debt consolidation, and debt settlement. Although these approaches may sound similar, they are very different from one another and are not suitable for all situations.
What is Debt Settlement?
Debt settlement, which is often referred to as Debt reliefis a process of authorizing a company to negotiate with your creditors to settle your debts for less than you owe. If successful, the savings can be significant; You could Reduce your balance by up to 50%, saving you thousands.
However, it is a risky process.
“If your accounts are current at the time you enroll in debt settlement, you will be asked to place those accounts in default. This is often a tactic they use to try to improve their negotiating position,” said Bruce McClary, senior vice president of membership and communications at the National Foundation for Credit Counseling. “But unfortunately, your good credit and finances are at stake.”
If you miss your payments, it could damage your credit score and there is no guarantee of success. Some creditors have policies prohibiting negotiations with debt settlement companies, so this will not stop debt collection activity or litigation.
Companies also charge high fees for their services; Generally, they charge 15 to 25% of your registered debt. And if they manage to negotiate a deal, the forgiven amount will be considered income for tax purposes, meaning you’ll face a significant tax bill.
Debt settlement can be an effective tool as a last resort, but it can only be used for unsecured debt and private student loans. Secured loans and federal student loans are not eligible.
What is Debt Consolidation?
Debt consolidation is the process in which you take on an unsecured debt private loan and use it to pay off your existing credit card balances and other debts. From now on you will receive a monthly payment.
Personal loans typically have lower interest rates than credit cards, so people with credit card balances may find that debt consolidation can help them save thousands in interest charges and get out of debt faster. And because the loan pays off your existing balance, your credit utilization will improve and you could see an improvement in your credit score.
Although debt consolidation can be effective for some borrowers, it does not solve the problems that caused you to go into debt in the first place. If you don’t figure out the root causes, you may just make the problem worse.
“If for some reason you are unable to pay the debt, you will end up in even more debt than you started with,” Block warned.
To qualify for the lowest possible interest rates, you generally need to have very good to excellent credit, and not all forms of debt can be paid off with a debt consolidation loan. For example, many lenders prohibit using a debt consolidation loan to pay off secured debts or Student loans.
What is a Debt Management Plan (DMP)?
A DMP is a program offered by nonprofit credit counseling agencies. When you take out a DMP, the credit counseling agency will contact your creditors on your behalf. Because of the agreements they have negotiated with many large corporations, banks, and credit unions, they can often convince your creditors to lower your interest rates and waive late fees, helping you save money.
“Nonprofit credit counseling agencies have relationships with the various creditors so we can significantly reduce interest rates,” said Madison Block, product marketing manager at American Consumer Credit Counseling. “So, your interest rate [on existing credit card debt] could be more than 20%. And in some cases we can reduce the value to almost zero.”
You make a one-off payment to the credit counseling agency, which receives it and pays it out to your creditors based on an agreed repayment plan. The advisor will work with you to develop a budget and spending plan to help you stay on track.
With a DMP you can become debt-free in three to five years and potentially save a significant amount of money.
DMPs incur setup fees and monthly account fees. However, because DMPs are run by nonprofit organizations, fees are typically relatively low, and if you have a lower income, you may be eligible for fee waivers or reductions.
However, DMPs typically only apply to unsecured debts, such as: B. Credit card balances and medical bills. Other forms of debt such as mortgages, car loans or student loans are not eligible. You must also agree to close your credit accounts. So if you rely on credit cards, it can be difficult to avoid credit.
Taking that away
If you’re struggling with debt, deciding on a path forward can be daunting. DMPs, debt consolidation, and debt settlement are commonly recommended strategies for getting out of debt, but they are very different processes with their own advantages and disadvantages. Knowing how they work, their benefits, risks and fees will help you make an informed decision.
As you evaluate your options, keep in mind that scams and fraudulent companies are common. Do your organization homework before making any commitments.
“Don’t feel pressured to make an immediate decision while you’re on the phone,” McClary warned. “Take enough time to think about the different options and make the right decision.”
If you’re not sure where to start, meeting with a nonprofit credit counselor or certified financial advisor may be helpful. They will review your finances and debts and identify all of your potential options, including the possibility of purchasing them government aid programsso that you can decide on the next steps.
To find a reputable advisor or consultant, visit NFCC.org or CFP.net.