Debt Management Plans vs. Bankruptcy vs. Debt Consolidation vs. Debt Settlement
When you carry high levels of consumer debt, it takes an emotional toll on your life. The worry that looms over you about your ability to pay your creditors timely can be overwhelming, especially if you are living paycheck to paycheck or recently experienced a hardship – such as loss of a spouse, a reduction in income or another financial setback -. Having more debt than you can handle has more consequences than just increased stress. If you miss your monthly payments, your credit score will start to decrease, which can impact your ability to obtain a home mortgage or other loans you may need in the future. If you are worried about meeting your financial obligations, such as credit cards, our financial advocates can teach you how to manage your consumer debts. We take a holistic approach to improving your financial health by providing credit counseling and education to explore repayment options, helping you achieve your financial goals. We will walk you through various repayment options, including the Debt Management Plan (DMP), which we offer, and help you understand the difference(s) between a DMP and other “for-profit” options, such as debt settlement and debt consolidation. Each of these options has short-term and long-term consequences that you need to understand.
Debt Management Plan
For over 50 years, we have been helping our clients safely repay their credit card and other unsecured debt obligations through a Debt Management Plan (DMP). A DMP allows you to structure payment plans with creditors and stop late fees or collection efforts. A DMP is a voluntary agreement that establishes a repayment schedule allowing you to repay your full balance to your creditors typically within 2 to 5 years. Once set up, the DMP allows you to make a single monthly payment to a consumer credit counseling agency such as CCCSMD (Consumer Credit Counseling Service of Maryland and Delaware, Inc.). In turn, the counseling agency disburses your monthly payments to the creditors participating in the DMP.
Creditors are usually receptive to working with you, as long as consistent payments are made on a thirty-day cycle. While on a DMP, you still receive your creditor statements. The benefits of getting on a DMP are:
- Paying off unsecured debt included in the plan within 5 years or less,
- Reduced interest and fees,
- One consistent monthly payment,
- Personalized support, and
- Will help you build or rebuild your credit when consistent payments are made.
While on a DMP, you have to agree to refrain from using credit (except in the case of an emergency). Be aware that there are some for-profit companies that offer a similar service but who charge large fees for these services. Nonprofit agencies, such as CCCSMD, only charge nominal, state-regulated fees and provide services regardless of an individual’s ability to pay.
There are two types of bankruptcy that our Financial Advocates can walk you through: Chapter 7 and Chapter 13.
A Chapter 7 wipes out all qualifying debt to allow for a “fresh start”; but the trustee, who is an individual appointed by the court (but not an employee of the court) to oversee your bankruptcy, can sell your non-essential property. There are no monthly payments on the qualifying debt, but certain debts typically cannot be included such as 1) child and spousal support, 2) income taxes incurred in the last three years, 3) some pending legal awards, and 4) student loans (unless there are extreme circumstances where there is proven repayment hardship). If you have enough disposable income to sustain a Chapter 13 repayment plan (see below), a Chapter 7 won’t be an option for you.
A Chapter 13 is a reorganization of debt that allows you to keep all of your property, but you’ll have to keep up with secured debt payments and catch up on secured debt arrears The reorganization requires you to pay creditors the value of your nonexempt property as part of the three to five-year payment plan through the bankruptcy. The payment plan, also referred to as wage earner bankruptcy, is based off of 1) how much you owe, 2) the value of your nonexempt property, and 3) how much income you earn. Chapter 13 is often a strategy used to prevent foreclosure, stop collection activity, or avoid repossession.
Bankruptcy is a personal choice that needs to be considered very carefully. Bankruptcy can offer immediate relief but it may have a long-term, negative impact on your ability to access affordable credit options and it will remain on your credit report for up to 10 years.
The concept of debt settlement – a product offered by for-profit companies – is that you might be able to pay off your unsecured debt (credit card debt; utility bills; medical debt) for less than what you owe. Debt settlement has tremendous appeal on the surface with the promise of paying as little as half of the principal amount owed on the debt. Some for-profit debt settlement companies (also known as “debt relief” or “debt adjusting” companies) may be successful at reducing your debt, but you should be aware that their services and programs also come with risks that could leave you deeper in debt.
First, there is no guarantee that debt settlement companies will be able to reach a settlement agreement with your creditors. Accounts considered for settlement must typically be 3-4 months delinquent before creditors consider negotiating. During that time, late and over-limit fees, as well as interest, continue to be added to your balance. For example, if you initially owed $5,000 when negotiations began, and you were hoping that the creditor would settle for $2,500, the amount owed could be much higher by the time an agreement is reached.
Debt settlement can also be expensive. Reputable debt settlement companies can’t collect a fee until 1. they’ve reached a settlement agreement, 2. you’ve agreed to the settlement, and 3. you’ve made at least one payment to the creditor or debt collector as a result of the agreement. As soon as those three requirements are met on one debt, the company can start charging you that proportion of its total fee. For example, if your total debts came to $10,000, and a debt relief company settled $5,000 of the total amount, it’s allowed to charge 50% of the total agreed-upon fee.
Debt settlement can also have a negative impact on your credit. A debt settlement company will typically encourage you to stop making payments on your debts while you save up money for a lump-sum payment. However, your creditors might not have agreed to settlement yet, which means all those payments you’re missing can wind up as delinquent accounts on your credit reports.
It is also possible that your creditors will eventually send your account to collections and/or sue you over the debt. Settlements could also impact your tax return as the IRS may count the amount forgiven as income.
Finally, please note that the overall duration of a debt settlement may well exceed the duration of a DMP. The majority of CCCSMD clients fully pay off their unsecured debts in less than 3 years.
Debt consolidation entails taking out one loan to pay off others and can take many forms, such as obtaining a loan from a financial institution to payoff other creditors, transferring credit card balances to a zero or low-interest card, accessing funds through a 401K, or using a home equity product. Unsecured debt such as credit card balances, medical bills, or personal loans are rolled into one account and a single monthly payment.
On the surface, this approach may seem attractive as you can lower your total monthly payments, freeing up more cash initially, and lowering interest rates. But you have to also consider some of the possible consequences:
- Transferring balances to another credit card can cost as much as 3% of the amount transferred.The zero or low rate new card may be for a limited time and, if you miss a payment, the rates can increase dramatically.
- Withdrawing retirement funds (such as from 401K) early can result in paying taxes on the withdrawal and a 10% penalty fee.
- Home equity loans or lines of credit reduce the amount of equity you have available.Adding additional liens against your home can make it more difficult to sell your home if its value is close to the amount you owe on your mortgage and any lines of credit.
Debt consolidation can be a viable option if you have good credit and can qualify for more desirable interest rates which result in lower overall repayment costs.
One of the most common concerns with debt consolidation is the likelihood that you will be tempted to continue to use the credit cards that were paid off, resulting in increased debt levels.
Choosing how to Manage your Debt
CCCSMD can help you navigate through the different options available. We’ll start by discussing your financial goals, review your entire financial picture – including your budget and credit report – and will brainstorm the best solution for you. For immediate assistance, call us at 1-800-642-2227 or contact us online to speak with one of our certified Financial Advocates.