How Does Debt Relief Work? Understand Your Options and the Consequences

Debt relief can ease the burden of overwhelming debt, but it's not right for everyone. Here are options to explore.
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Written by Bev O'Shea
personal finance writer
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Edited by Kathy Hinson
Lead Assigning Editor
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Find that you're just not making progress on your debt, no matter how hard you try? If that's the case, it could be time to consider your options for debt relief.

What is a debt relief program?

Debt relief tools can change the terms or amount of your debt so you can get back on your feet more quickly.

A debt relief program could involve:

  • Wiping the debt out altogether in bankruptcy.

  • Using a debt management plan to get changes in your interest rate or payment schedule.

  • Negotiating with creditors to settle the debt for less than the full amount owed.

But debt-relief programs are not the right solution for everyone, and it’s important to understand their potential risks.

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When you should seek debt relief

Consider bankruptcy, debt management or debt settlement when either of these is true:

  • You have no hope of repaying unsecured debt (credit cards, medical bills, personal loans) within five years, even if you take extreme measures to cut spending.

  • The total of your unpaid unsecured debt equals half or more of your gross income.

On the other hand, if you could potentially repay your unsecured debts within five years consider a do-it-yourself plan. That could include a combination of debt consolidation, appeals to creditors and stricter budgeting.

Be aware of scams, debt relief downside

The debt relief industry includes scammers who are eager to take what little money you have. Many people who enter debt relief programs fail to complete them. You could end up with debts that are even bigger than when you started.

But debt relief may also give you the new start or the breathing room you need to finally make real progress.

Be sure you understand — and verify — these points before entering any agreement:

  • What you need to qualify.

  • What fees you will pay.

  • Which creditors are being paid, and how much. If your debt is in collections, make sure you understand who owns the debt so payments go to the right agency.

  • The tax implications.

Avoid debt relief programs that promise to do any of the following:

  • Make you pay a fee before your debt is settled.

  • Guarantee a “too good to be true” price for paying off your debt.

  • Assure you that it can stop all calls from debt collectors.

Debt relief through bankruptcy

There’s little point in entering a debt settlement or debt management plan if you’re not going to be able to pay as agreed. Talk with a bankruptcy attorney first. Initial consultations are often free, and if you don’t qualify, you can move on to other options.

The most common form of bankruptcy, Chapter 7 liquidation, can erase most credit card debt, unsecured personal loans and medical debt. It can be done in three or four months if you qualify. What you should know:

  • It won’t erase taxes owed or child support obligations, and student loan debt is highly unlikely to be forgiven.

  • It will hurt your credit scores and stay on your credit report for up to 10 years. However, if your credit is already damaged, a bankruptcy may allow you to rebuild much sooner than if you keep struggling with repayment. (Learn more about when bankruptcy is the best option.)

  • If you have used a co-signer, your bankruptcy filing will make that co-signer solely responsible for the debt.

  • If debts continue to pile up, you can’t file another Chapter 7 bankruptcy for eight years.

  • It may not be the right option if you would have to give up property you want to keep. The rules vary by state. Typically, certain kinds of property are exempt from bankruptcy, such as vehicles up to a given value and part of the equity in your home.

  • It may not be necessary if you’re “judgment proof,” which means you don’t have any income or property a creditor can go after.

Also, not everyone with overwhelming debt qualifies. If your income is above the median for your state and family size, or you have a home you want to save from foreclosure, you may need to file for Chapter 13 bankruptcy.

Chapter 13 is a three- or five-year court-approved repayment plan, based on your income and debts. If you are able to stick with the plan for its full term, the remaining unsecured debt is discharged. If you are able to keep up with payments (a majority of people are not), you will get to keep your property. A Chapter 13 bankruptcy stays on your credit report for seven years from the filing date.

Debt relief through a debt management plan

A debt management plan allows you to pay your unsecured debts — typically credit cards — in full, but often at a reduced interest rate or with fees waived. You make a single payment each month to a credit counseling agency, which distributes it among your creditors. Credit counselors and credit card companies have longstanding agreements in place to help debt management clients.

Your credit card accounts will be closed and, in most cases, you’ll have to live without credit cards until you complete the plan. (Many people do not complete them.)

Debt management plans themselves do not affect your credit scores, but closing accounts can hurt your scores. Once you’ve completed the plan, you can apply for credit again.

Missing payments can knock you out of the plan, though. And it’s important to pick an agency accredited by the National Foundation for Credit Counseling or the Financial Counseling Association of America.

As always, make sure you understand the fees and what alternatives you may have for dealing with debt.

Debt relief through debt settlement

Debt settlement is a last resort for those who face overwhelming debt but cannot qualify for bankruptcy or simply don't want to file bankruptcy.

Debt settlement companies typically ask you to stop paying accounts you enroll in the plan and instead put the money in an escrow account. Each creditor is approached as the money accumulates in your account and you fall further behind on payments. Fear of getting nothing at all may motivate the creditor to accept a smaller lump-sum offer and agree not to pursue you for the rest.

Beware that you could end up with debts that are even bigger than when you started, acording to the Consumer Financial Protection Bureau. Late fees, interest and other charges related to credit card debt could make your debt balloon — because many debt settlement companies will ask you to stop making debt payments to try to sway creditors into negotiating

Not paying your bills can result in collections calls, penalty fees and, potentially, legal action against you. Lawsuits can lead to wage garnishments and property liens. Debt settlement stops none of that while you're still negotiating, and it can take months for the settlement offers to begin.

Depending on how much you owe, the process could take years and the continued late payments further damage your credit score. You may also face a bill for taxes on the forgiven amounts (which the IRS counts as income).

You can attempt to settle a debt yourself, or you can hire a professional. The debt settlement business is riddled with bad actors, though; the Consumer Financial Protection Bureau, the National Consumer Law Center and the Federal Trade Commission caution consumers about it in the strongest possible terms.

Some of those companies also advertise themselves as debt consolidation companies. They are not. Debt consolidation is something you can do on your own, and it will not damage your credit.

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Do-it-yourself debt relief

You can borrow from some of the above-listed debt relief options and create your own plan.

For example, you can do what credit counselors do in debt management plans: Contact your creditors, explain why you fell behind and what concessions you need to catch up. Most credit card companies have hardship programs, and they may be willing to lower your interest rates and waive fees.

You can also educate yourself on debt settlement and negotiate an agreement by contacting creditors yourself. (Learn how you can negotiate a debt settlement on your own.)

If your debt isn’t unsurmountable, more traditional debt-payoff strategies may be available. For example, if your credit score is still good, you may be able to get a 0% balance transfer credit card. The interest-free period means your whole payment goes to reducing the balance, making faster progress. Or you may find a debt consolidation loan with a lower interest rate than you're paying now.

Those options won’t hurt your credit; as long as you make the payments, your credit score should rebound.

If you go this route, however, it’s important to have a plan to avoid adding more credit card debt.

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What not to do

Sometimes overwhelming debt comes with devastating swiftness — a health crisis, unemployment or a natural disaster. Or maybe it came a little at a time, and now creditors and collection agencies are pressing you to pay, and you just can’t.

If you’re feeling overwhelmed by debt, here are some things not to do:

  • Don’t neglect a secured debt (like a car payment) in order to pay an unsecured one (like a hospital bill or credit card). You could lose the collateral that secures that debt, in this case your car.

  • Don’t borrow against the equity in your home. You’re putting your home at risk of foreclosure and you may be turning unsecured debt that could be wiped out in bankruptcy into secured debt that can’t.

  • Don’t withdraw money from your retirement savings in order to repay unsecured debt. This cuts your chances of a financially secure retirement.

  • Think twice about borrowing money from workplace retirement accounts as well. If you lose your job, the loans can become inadvertent withdrawals and trigger a tax bill, which is the last thing you need.

  • Don’t make decisions based on which collectors are pressuring you the most. Instead, take time to research your options and choose the best one for your situation.

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