How to Make Your Debt More Manageable
You’ve probably seen the ads—debt-settlement companies promise to help people who are drowning in debt slash the amount they owe. These services can be a viable option for some debtors, but there are risks and downsides. And there are alternatives, such as debt consolidation and credit counseling.
Bottom Line Personal asked debt specialist Gerri Detweiler to explain the options and help you determine where you should turn for help managing your debt…
Organizations like Accredited Debt Relief and National Debt Relief try to convince lenders to accept less than the full amount owed. To accomplish this, settlement companies first instruct their clients to stop making payments on their debts. Reason: Lenders have little incentive to settle when borrowers are making their payments. Instead, these companies instruct their clients to make payments into an account, creating a pool of money that the debt-settlement company will use to pay the negotiated settlement amount later, assuming all goes as planned. But there are some caveats worth noting…
Debt settlement is only for unsecured debts, such as credit card balances. It won’t work with car loans, mortgages and other secured loans. If a borrower stops making payments on these loans, the lender won’t agree to accept less…and it will repossess the car or foreclose on the home.
Debtors can end up worse off if lenders won’t play ball. Lenders sometimes reject debt-settlement offers and rely on collection agencies. When that happens, debtors who have followed the debt-settlement strategy of not making debt payments are left with even more accumulated interest charges and penalties than they had before. They also might face phone calls from debt collectors, lawsuits by lenders and debt-collection agencies and/or garnished wages.
Credit scores take a hit. Ceasing debt payments is a surefire path to a lower credit score. How much lower depends in part on how low the debtor’s score was before attempting this strategy. Someone with a high credit score would likely see a bigger drop by stopping payments than someone whose score was already low.
Debt-settlement companies charge steep fees—potentially as much as 25% of the amount owed, though this varies.
Any debt reduction likely will be taxable. Forgiven debts typically are taxed as income. But there are exceptions to this, so it’s worth discussing the matter with a tax professional. For more information: See “Canceled Debt—Is It Taxable or Not” at IRS.gov/taxtopics/tc431.
Debt consolidation involves shifting high-interest rate debt into new lower-rate loans or onto lower-rate credit cards. Debt consolidation has less downside than debt settlement—the fees involved tend to be much lower…it doesn’t significantly damage credit scores…and it doesn’t depend on existing lenders agreeing to terms. But: Debt consolidation often isn’t an option for people who are drowning in debt—their credit scores and overall financial picture could be too damaged to qualify for low-rate loans or cards. Such people might still qualify for a low-rate secured loan, such as a home-equity loan, but that’s risky—if they later fall behind on their payments on the home loan, they could lose the home.
Nonprofit credit-counseling services help clients reduce debt, typically with lower interest charges and monthly payments, not by reducing the debts themselves. But rather than use a settlement company’s hardball tactics, these nonprofits work with lenders to craft payment plans that fit in their clients’ budgets—typically by lowering interest charges and monthly payments, not by reducing the debts themselves. Use of these nonprofits generally doesn’t result in damaged credit scores, huge fees or big tax bills—though credit card issuers often cancel the cards of people who pursue this strategy. As the word “counseling” implies, these nonprofits also offer debt-management advice. Similar: Cardholders also can attempt to negotiate payment plans directly with card issuers, rather than have a credit-counseling service act on their behalf—but that can become impractical when more than a few card issuers are involved.
Bankruptcy sometimes is the least-bad option for people who lack any realistic way to pay off their debts. It can be more effective and less expensive than debt settlement—the fees charged by debt-settlement companies often exceed those charged by bankruptcy lawyers. Among the downsides: Bankruptcy will remain on a credit report for seven or 10 years, depending on the type of bankruptcy…it sometimes costs people their homes, depending on their state’s “homestead exemption” rules…it can negatively affect someone’s ability to obtain or retain certain professional licenses and security clearances…it can rob people of their financial privacy—bankruptcies are a matter of public record…and it can create significant financial problems for any loved ones who co-own property with the individual who declares bankruptcy.
Contacting a debt-settlement company should not be the first step for people seeking debt solutions. Instead, start by attempting to consolidate to low-rate loans. If such loans are not available to you and/or don’t provide sufficient debt relief, contact a nonprofit credit-counselling service. If this nonprofit can’t offer a viable solution, speak with both a bankruptcy attorney and a debt-settlement company before choosing either of these options. Debt settlement is most likely to be the best available option when a debtor owes more than he/she can reasonably pay and has very limited assets and income that a creditor could hope to obtain if it rejected the debt settlement and instead sued the debtor.
If you opt for debt settlement: Choose the settlement company carefully—fees can vary, and there are disreputable players in this sector.
