The pros and cons of debt relief programs

If you’re feeling overwhelmed by debt, you might consider debt relief programs to help you retake control of your finances. These programs can make debt more manageable by reducing interest rates, changing payment terms or even canceling some of the debt.

It’s important to understand the financial consequences of debt relief plans. Some plans can leave you with hefty fees or even more damage to your credit score.

Hanna Horvath, Certified Financial Planner (CFP) and Red Ventures Senior Editor, explains that debt relief programs can benefit those struggling with high-interest debt. However, there are also some potential downsides.

What is debt relief?

Debt relief is the process of reorganizing debts to make them more manageable. This can mean consolidating multiple debts into one monthly payment, settling a debt for less than you owe or working with a credit counselor to create a strategic plan for repaying debt.

Multiple debt relief options are available, so it’s important to weigh the pros and cons of each to determine which method is best for you.

Debt consolidation

Debt consolidation is combining two or more existing debts into one new debt. Some of the most common methods are with a loan or a balance transfer credit card.

With a debt consolidation loan, you take out a new loan to repay all the existing debts and make payments on the new loan. A balance transfer credit card typically offers a 0 percent introductory rate to give you a temporary break from incurring interest. You’d pay off your debts with that card and then pay off the card. If you can pay it off before the promotional period ends, you’ll save a lot of money in interest.

Whether you use a debt consolidation loan, a balance transfer credit card or another consolidation method, you’ll still owe the same total balance you started with. However, you’ll only need to make one monthly payment instead of multiple. This can simplify your payments and make the debt feel more manageable.

There are numerous benefits and minimal risks compared to other options — provided you can keep up with payments.

Debt consolidation pros

• You'll simplify your monthly payments.
• It may help save money on interest, pay down debt faster or both.
• Debt consolidation loans can offer lower fixed interest rates, a fixed monthly payment plan and a set repayment schedule.
• A balance transfer credit card can get you 0 percent APR for up to 21 months.
• Consolidating with a personal loan may increase your credit score.

Debt consolidation cons

• You need good or excellent credit to qualify for loans with the best rates and terms.
• You may owe fees, such as balance transfer fees if you use a card or an origination fee if you get a new loan.
• Balance transfer cards’ 0 percent APR periods typically last 12 to 21 months, after which you’ll face a variable interest rate on any remaining balance.

Debt settlement

Debt settlement is a process that allows you to discharge large debts for less than you owe by making a significant upfront payment. This means you need a lump sum of cash you can pay the creditor in exchange for forgiving part of your debt.

Debt settlement is offered through for-profit debt settlement companies. You can also opt for a DIY debt settlement process to avoid fees. Debt settlement through a company is a last-resort option after you haven’t been able to make payments for a while or find other debt relief options.

A creditor may agree to settle debt for less in exchange for a lump sum because the promise of some money is better than you not paying at all. However, fees may be involved and a company may sell your debt to a collections agency instead of negotiating.

If the creditor agrees to a settlement, you’ll make your lump-sum payment, and the debt is discharged. When working with a debt settlement company, you pay the company, which passes your payment to the creditor after deducting its fees. Settlement fees vary depending on the company, but are typically about 15 percent to 25 percent of the settled debt.

Unlike bankruptcy, when you pursue debt settlement creditors can sue you for nonpayment. For this reason, some experts consider bankruptcy a better option than debt settlement.

Debt settlement pros

• You may be able to settle your debt for less than you currently owe.
• You don’t have to communicate with creditors directly if you use a debt settlement company.

Debt settlement cons

• Creditors are not legally required to settle for less than you owe.
• Missed payments on your bills to be able to negotiate will damage your credit score.
• Debt settlement companies often charge fees.
• The creditor may require you to close the account, which will result in losing access to that credit line.
• The amount of forgiven debt may be considered taxable income by the IRS, so there may be tax implications.
• The amount you owe may increase because of late fees or penalty interest even if the original owed amount is reduced.

Credit counseling

Credit counseling involves seeking help from financial experts to manage your finances. You’ll be assigned a counselor to examine your current debts and income, and they will create a financial plan based on your monthly budget to help you repay your debts. They may even be able to negotiate with your creditors to temporarily reduce the interest rate or waive fees on your account.

Credit counseling agencies can be for-profit or nonprofit. Nonprofit counseling agencies typically charge lower fees than for-profit agencies, with some offering their services for free. For-profit companies may charge higher rates and be incentivized to sell you their services.

Some agencies also offer long-term financial health assistance and immediate debt management services, such as free training and workshops on improving your relationship with money.

Credit counseling pros

• Nonprofits offer low-cost or free services.
• Receive financial advice tailored to your specific debts and income.
• Gain access to resources that promote immediate and long-term financial health.

Credit counseling cons

• Not all credit counseling agencies are reputable, so you’ll have to do your research.
• For-profit counseling comes with higher fees.

Debt management

Debt management involves budgeting and financial planning to get debt under control. This is often used with credit counseling companies, which may recommend and oversee a debt management plan (DMP) for you. You can also create your own DMP using debt management calculators.

Common debt management strategies include the debt snowball and the debt avalanche. In both cases, you pay more than the minimum balance on one specific debt while paying only the minimum on all other debts. Once your focus debt is paid in full, you funnel that amount to the next debt on your list.

With the debt snowball, you focus on the debt with the lowest balance first. With the debt avalanche, you focus on the debt with the highest interest rate first.

If you work with a credit counselor on your DMP, you will make a single monthly payment to an account in your name, and the company will use this money to pay bills on your behalf.

Debt management pros

• You have the potential to save money on interest expenses.
• It may allow you to get out of debt faster.
• If a credit counselor administers your DMP, it will simplify your finances because you’ll have just one debt payment to make each month.

Debt management cons

• DMPs through a credit counselor may require you to stop using credit cards.
• Fees for DMPs from for-profit companies can be steep.

Bankruptcy

Bankruptcy is another last-resort option. It’s a long, expensive process with long-term negative impacts on your credit score. However, bankruptcy can be helpful as it provides a break from creditors and may result in discharged debt.

There are two main types of bankruptcy: Chapter 7 and Chapter 13. Both types help you discharge certain debts and get a fresh start.

Chapter 7 bankruptcy requires you to liquidate most property to pay off your creditors. The remaining qualified debt is discharged. Chapter 13 bankruptcy puts you on a three- to five-year court-approved payment plan, which may have lower interest rates or smaller payments compared to your current debt.

Bankruptcy pros

• It may result in having certain debts reduced or discharged.
• The process stops calls from creditors and debt collectors.
• Bankruptcy is often faster than something like debt settlement, which means you can rebuild credit sooner.
• You may be able to keep your home or a car.

Bankruptcy cons

• Chapter 7 stays on your credit report for up to 10 years, and Chapter 13 stays for up to seven years following the filing date.
• Both types cause significant credit score damage and may make qualifying for new unsecured credit difficult.
• Not all debts qualify for bankruptcy. Secured loans and federal student loans are typically excluded from discharge.

When should you consider a debt relief program?

Debt relief may not be the right approach for everyone. But there are some cases when it can be an option worth considering.

• Multiple costly debts: If you’re bogged down by multiple high-interest debts, debt relief may help you reduce some of this burden and allow you to pay the remaining debt more quickly.
• Unable to make payments: If you’re no longer making the minimum payments on your debt, it may be time to consider a debt relief program. A debt relief program may be able to help reduce your monthly payments, allowing you to get back on track.
• Loss of income: If you’ve experienced an unexpected loss of income that will prevent you from servicing your debt, it can be helpful to pursue debt relief, rather than simply letting the debt go unpaid.

The bottom line

If you find yourself overwhelmed with debt, a debt relief program can help you manage the debt and move forward financially. It’s important to understand your options — and the pros and cons of each debt relief program.

If you want professional assistance, compare debt relief companies carefully to find a reputable firm that meets your needs.

Frequently asked questions

• Does debt relief hurt your credit?

  It depends on the debt relief program you use. Some programs, like credit counseling and debt management, are less likely to hurt your credit than more drastic options like debt settlement or bankruptcy.

• Do you have to repay loans if you use a debt relief program?

  In most cases, you’ll still repay your loans. However, some of your debt may be forgiven under certain programs, such as debt settlement and bankruptcy. Your credit will take a major hit under those options, so they should be a last resort.

• How much do debt relief programs cost?

  The cost of debt relief depends on the type of program you use, the company you choose, and the amount of debt you’re dealing with. If you are concerned about cost, you should start by seeking the advice of a nonprofit credit counseling service.