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Understanding Debt Management and Debt Settlement
Paying off debt can be challenging, especially if your credit is in poor shape and your budget is tight. Debt settlement and debt management plans can provide relief, but they are very different options with distinct ramifications. Here’s a detailed look at how debt management and debt settlement work and what to consider before choosing either path.
What Is Debt Management?
A debt management plan (DMP) is a structured repayment plan administered by a credit counseling agency. It works similarly to debt consolidation by combining all your unsecured debt payments, usually credit cards, into one. Once the DMP is established, you’ll make a single payment to the credit counseling agency, which will distribute the funds to your creditors. The agency may also negotiate lower interest rates and monthly payments with your creditors, and the repayment plan typically lasts three to five years.
Pros and Cons of Debt Management
Pros
- Doesn’t cause lasting credit damage: While some aspects of a DMP can negatively impact your credit, it won’t create yearslong damage like debt settlement or bankruptcy. In fact, a DMP can help you improve your credit score over time by helping you stay on top of making on-time payments.
- Provides payment relief: With a reduced interest rate and lower monthly payment, you could save a lot of money and may have an easier time sticking to a repayment plan. Only having one monthly payment can also make the process simpler.
- Has a set repayment term: Credit cards don’t have structured repayment terms, which can make it more challenging to pay them off quickly. With the structure of a DMP, you’ll have a better idea of when you’ll be debt-free.
Cons
- Can damage your credit in the short term: You’ll likely be required to close your credit card accounts when including them in a DMP, which can cause your credit utilization rate to spike. This can cause your credit score to drop, though not as drastically as debt settlement or bankruptcy. The good news is that your credit score will recover as you pay down your balances.
- No new credit: You typically can’t open new credit accounts when you’re on a DMP. If you’ve relied on credit cards and other forms of credit to get by, this can significantly impact your spending power.
- May not be cheap: Agencies charge an upfront fee to set up a DMP and ongoing monthly fees, and depending on which agency you work with, you may end up paying more than you need to. Ensure you’re working with a reputable nonprofit agency by searching for a credit counselor through the National Foundation for Credit Counseling or the Financial Counseling Association of America.
What Is Debt Settlement?
Debt settlement involves negotiating with a creditor to pay less than the full amount you owe. You can settle a debt on your own or work with a debt settlement company or law firm. If you work with a company or law firm, they’ll typically encourage you to stop making debt payments while they negotiate terms with your creditors. Because a debt settlement typically requires a lump-sum payment instead of a restructured repayment plan, you’ll typically need to deposit money into a dedicated account with the company or firm, which it will use for the settlement.
Pros and Cons of Debt Settlement
Pros
- Can provide relief in a dire situation: If you’re overwhelmed and other debt repayment options, including debt consolidation and DMPs, aren’t feasible, debt settlement could help you get out from under a significant financial burden.
- Helps you avoid bankruptcy: While debt settlement can do more damage to your credit history than a DMP, it won’t be as bad as bankruptcy.
- Can prevent other consequences: If you can negotiate a settlement with your original creditor, you may be able to avoid having the debt sent to collections, which can compound your credit issues. Settling with a debt collection agency can also save you from a lawsuit, which could result in wage garnishment and other drastic measures.
Cons
- Can be costly: If you hire a debt settlement company or law firm, you may have to pay a hefty fee for their service, reducing your savings. If you stop making payments during the negotiation process, the creditor may add late payment charges and collection fees to your balance, increasing how much you owe. Finally, if the creditor does forgive a portion of your debt, you may need to report the amount as income on your tax return, which could result in a tax bill.
- Can devastate your credit: A debt settlement indicates that you didn’t pay as originally agreed, and because your payment history is the most important factor in your FICO® Score, it can be devastating for your credit profile. A settlement will remain on your credit reports for seven years from the original delinquency, so if you’re already behind on payments, much of the damage may have already been done. But if you’re still paying on time, consider other options.
- No guarantee it’ll work: Because you have a contract with your lender, it has the right to refuse your attempt to settle. In fact, some creditors may have a policy against working with debt settlement companies and law firms. Even if you do get a creditor to come to the table, settling may not get you the savings you’re hoping for.
Debt Management vs. Debt Settlement: Which Is Better?
Ultimately, the decision to get on a DMP or to settle for less than what you owe depends on your current situation, budget, and options. Here’s a quick recap of how the two processes differ:
| Feature | Debt Management Plan | Debt Settlement |
|---|---|---|
| Repayment | Provides a structured repayment plan over three to five years | Typically involves a lump-sum payment |
| Relief | A credit counseling agency can negotiate lower interest rates and monthly payments and combine multiple payments into one | Satisfies your debt for less than what you owe |
| Costs | Typically requires an initial setup fee of $30 to $50 and a monthly fee ranging from $20 to $75 | Debt settlement companies may charge 15% to 25% of the debt amount; creditors may tack on late fees and collection charges if you stop making payments; forgiven debt may be subject to income taxes |
| Credit score impact | Closing your credit cards can cause your utilization rate to spike, hurting your credit score until you pay off the debt | Missing payments during the negotiation process can damage your credit score, as can the settlement itself; these items remain on your credit reports for seven years from the original delinquency |
| Other risks | Creditors may cancel the DMP if you miss a payment or apply for other credit during the repayment period | Creditors may not be willing to negotiate with you |
| When to consider it | Your credit score needs some work, and you don’t qualify for or can’t afford debt consolidation | You’re already behind on payments, and neither debt consolidation nor a DMP is feasible |
Carefully Consider Your Situation to Determine How to Tackle Your Debt
Before you consider a debt management plan or debt settlement, take stock of your situation and research your debt repayment options. If you have great credit and room in your budget, for instance, a balance transfer credit card or debt consolidation loan may be worth considering. You can also look into accelerated repayment strategies.
On the other end of the spectrum, bankruptcy may be your only option if your financial situation doesn’t make anything else possible. Check your credit score before you proceed to better understand your options. If you’re overwhelmed, consider consulting with a credit counselor who can evaluate your situation and provide personalized advice, often free of charge.
For any mortgage service needs, call O1ne Mortgage at 213-732-3074. We are here to help you navigate your financial journey with expert advice and personalized solutions.
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