When your debts become overwhelming, it is often difficult to figure out what to do. Should you take on a second job, to earn extra income? Or, would it make more sense to borrow some money from family or friends, and use that to pay down your debts? 

Should you try to work with your creditors, to reduce the burden of your debts? Or , should you seek some outside help in doing so?

If you are currently dealing with any of these issues, you might have heard of debt relief. These companies claim that they can help you reduce the burden of debt, and get your finances on track. 

Yet, it is often not clear how exactly these services really work, and whether they are worthwhile. Let’s dig into the truth behind debt relief, and see whether it actually makes sense for you.  

The Basics of Debt Relief

While the exact techniques used by various debt relief firms varies, there is a general pattern to their approach. If you’re struggling to pay debts, especially credit cards, then you’re probably an ideal candidate for a debt relief agency.

The debt relief firm will review your finances, and figure out how much money you can afford to pay for settling various debts – as well as what credit card issuers are likely to agree to.The debt relief firm will usually instruct you to stop making payments on each of these cards. Of course, if you’re facing financial distress, then there’s a good chance you’ve already fallen behind on your accounts, and stopped making minimum payments. 

Once you’ve stopped paying, the debt relief firm will now contact each of your credit card issuers, and explain that you are now working with a debt relief agency. They will inform the card issuer that you’re unable to pay the full amount owed on the card, and so wish to settle for a lesser amount. A card issuer can choose to accept this offer, propose a counter offer, or reject any negotiation of the debt. 

Let’s suppose a card issuer and a debt relief agency (with the client’s approval) reach an agreement, on a lesser amount of money, to settle the debt for. They will agree on how long the client has to pay this settlement amount. Typically, you’ll be given between 2 to 4 years. 

At this point, a debt relief firm will have you start making payments each month, into an account created specifically for you. The account will be set up with an insured financial institution (i.e. a bank), and for legal purposes, is controlled by you. 

The debt relief firm will then submit payments, from this account, to the credit card issuer, until you’ve paid the settlement amount you agreed upon. If you stop making payments, or pay late, this could lead to the cancellation of the agreement with the card issuer. At that point, the entire amount originally owed would come due. 

This is a basic overview of the process. Now, let’s dive into the details.  

How Much Does Debt Relief Cost?

With a debt relief plan, if a creditor agrees to work with you, you should expect to settle for between 40% to 60% of the amount owed. However, that isn’t the only cost of debt relief. Most debt relief companies also charge a portion of the amount by which they’ve reduced your debts, or the total amount of debt you owed – usually between 15 to 25% of the total amount you owed, or the amount by which the debt was reduced. 

For example, if you had a credit card debt of $10,000, and a debt relief company is able to settle the debt for $6,000, they might charge you between 15% to 25% of $4,000 (the amount by which your debt was reduced). Or, you might have to pay 15% to 25% of the total original debt of $10,000 (so, between $1500 to $2500). These terms vary between debt relief agencies. 

If you are going to hire a debt settlement/relief firm, it is very important to keep in mind that these firms are not allowed to charge upfront fees, meaning, they can only charge once they have actually renegotiated at least one of your debts, you have agreed to at least one of these settlements, and you have made at least one payment towards settlement. 

Projected fees and costs must also be disclosed when you sign up. A debt relief agency cannot suddenly change the terms of the agreement, or come up with new costs you’ll have to pay. 

If you are seriously considering debt relief, it makes sense to contact at least several firms, to get a good idea of what sort of costs you’ll be looking at. Fees can vary, and you want to confirm you are paying a reasonable price. 

What If a Credit Card Issuer Refuses To Work With You?

As we noted earlier, a credit card issuer can either accept a settlement offer, make a counteroffer, or refuse to accept any settlement offer at all. Some credit card issuers refuse to work with debt settlement/relief companies.

At this point, several things can happen. Since you haven’t been paying on the debt, after 180 days, the debt will be charged off. This means that it is treated by the credit card issuer as a loss. A charge off also causes considerable damage to your credit score. 

The debt can be sold to a debt buyer. These companies specialize in pressuring consumers to pay debts. Typically, they’ll call and write to you. As an alternative, the creditor might simply attempt to collect on the debt themselves. 

In other instances, the credit card issuer, or the debt buyer who now owns the debt, might choose to file a lawsuit, to seek payment of the debt. If you owe $2,000 or more on the credit card, your chances of being sued increase considerably.

If you are sued, and the credit card issuer or debt buyer wins in court, they’ll now have a judgment against you. This can lead to your wages being garnished, and/or your bank account being frozen.

Defaulting on a debt has serious consequences. For this reason, if you are going to hire a debt relief agency, you might want to choose one which is also affiliated with or part of a law firm, so that they can represent you in any lawsuit you might face. 

In some cases, the credit card debt you stopped paying on will be forgiven. While this can mean that it won’t be included in the debt settlement plan. This can have tax consequences, since forgiven debts of $600 or more are treated as taxable income.

How Will Your Credit Be Impacted?

Debt relief impacts your credit in multiple ways. When you first stop paying on your debts, you’ll be marked as 30 days late, followed by 60 days, and so on. A single 30 day late marker can reduce your credit score by as much as 90 to 110 points. Having multiple accounts go into default will further damage your credit standing. 

For those debts which are settled by your debt relief agency, while you are repaying the debt, there might be a notation that the debt is in repayment. After you’ve completed repayment, the account will be listed “settled for less than full balance” or “settled for less than amount owed.” 

Such a notation will have a negative impact on your FICO credit score, for the entire time it appears your reports (typically 7 years). How much your credit score will be harmed depends on what else appears on your reports. 

Of course, keep in mind that settling a debt for less, and closing the account, is better than defaulting on a debt entirely (never paying). Also, if you were already behind on your payments before entering debt relief, then debt relief is likely to have less negative impact on your FICO score, than it would for someone who was making the minimum payments on the account each month. After all, in this case, your credit is already damaged. 

What Are Some Alternatives To Debt Relief?

Just as with any financial difficulty, you have options. Let’s take a look at a few of them.

Do It Yourself Debt Relief 

Everything that a debt relief company does are things you are capable of doing yourself. You can call and write to credit card issuers, and seek to settle your debts for less, and enter into alternative repayment plans. It makes complete sense to take charge of your finances.

Of course, you have to become comfortable with the process of negotiating with credit card companies. Obviously, they won’t be happy that you can’t pay your debts in full, and might pressure you to not seek settlement, or to pay more. However, if you are able to stay focused, rational, and control your emotions, it is very much possible for you to settle your debts and enter into payment plans on your own.

Debt Management

Suppose that you have a large amount of debt, and are facing challenges in paying it. However, you think you might be able to repay what you owe, if given enough time. You really want to avoid the negative credit impact of debt settlement. 

Debt management might be a good option for you. Here, you’ll once again sign up with a third-party company. However, you won’t be settling your debts for less.

Rather, you will enter into a debt management plan. This usually means that your credit card accounts will be closed, and you’ll have the interest rate you are paying on the existing balances reduced. Thus, your debt will accumulate less slowly. In some cases, you might altogether avoid paying interest on the remaining debt. 

You’ll be given some time (perhaps up to a few years), to repay this balance, by making monthly payments. These payments will be made through the debt management company, to whom you’ll pay a fixed amount each month, which will be sent to each credit card issuer.

By taking this approach, you’ll be able to get back on track with paying your debts on time, and avoid the negative consequences of settling a debt for less. You should note that in some cases, future lenders can see a debt management plan as less than favorable (ideally, you would have been able to pay all your debts on time, in full, without needing debt management). 

Debt Consolidation Through Balance Transfer Cards 

Another option for reducing your debts is through the use of balance transfer credit cards, or personal loans. With a balance transfer card, you’ll be able to move your existing credit card balances onto the balance transfer account, and pay 0% interest on these amounts transferred, for a period of 12 to 24 months. 

After that period of time, you will face an interest rate similar to that on standard credit cards – so it is important to pay down as much of your balance transferred, within that period. Also, balance transfer cards generally require at least decent credit – most of the highly desirable options require a FICO score of 650 or higher. 

With balance transfer cards, you are not settling your credit card debts for less, but rather, moving them from one credit card to another. In the short term (first several months), you will see your FICO score drop, since you opened a new account, and applied for credit. Your overall credit card debt would not have dropped, though your total credit limits have increased considerably. 

As you pay down the balance transferred, however, you’ll see your score start rebounding. Balance transfer cards act as a sort of “pause” button on your credit card debt, providing you with time to catch up and reduce your debts – without continuing to accumulate interest. 

The question, of course, is whether you can realistically bring down your credit card balances, after the transfer. Many people transfer balances, but are unable to really pay down the balance they transferred (i.e. they only make minimum payments). Essentially, they’re back in the same situation they were in before. 

Debt Reduction Through Personal Loans

Another option is to pay down credit card debts, through the use of personal loans. You’ll apply for a personal loan, and once you’ve been approved based on your credit and income, money will be sent to your bank account. You’ll use those funds to pay off some or all of your credit card debts, and then you’ll work on repaying the personal loan. 

One major advantage of personal loans is that they typically offer lower interest rates than most credit cards. While rates vary widely, loans are available at an APR as low as 5%, although rates in the range of 7% to 12% are more common. Personal loans do require at least decent credit in most cases, to obtain a competitive interest rate. Most of these loans won’t make sense unless you have a FICO score of at least 650, ideally higher.

Compared to balance transfer cards, personal loans suffer from one major disadvantage: you’ll be paying interest on the loans from day one. There is no grace period, during which you might avoid interest.  

However, personal loans are better for your credit, at least in the short term, than balance transfer cards. Personal loans greatly reduce (ideally, eliminate) your credit card debts, by paying them off with money from the loan. The FICO scoring formula penalizes a high ratio of credit card debt, relative to your credit limits. This means that the more credit card debt you have, the more your score is reduced. 

Installment account debt,, such as mortgage, auto loans, student loans, and of course personal loans, is  much less of a factor in determining your FICO score. This means that having a personal loan to pay off and replace your credit card debts (and then paying off the personal loan), is usually beneficial for your score, as compared to owing the same amount on your credit cards. 

The Debt Snowball Method

It is possible to reduce debt entirely on your own, without dealing with debt management or settlement companies, or using balance transfer cards or personal loans. One means of accomplishing this, is by use of the debt snowball method.

Here, you’ll first take a look at your monthly income, and your monthly expenses. You’ll then explore how you might reduce your expenses, and see how you might increase your income a bit. 

For example, you might stop eating lunch or dinner outside as often. To earn more money, you could start driving Uber once per week, or do some freelance graphic design, writing, or personal training – whatever you have time and some ability for. 

You will now take a look at your debts. For the sake of our example here, let’s assume you have three credit cards, each with high balances. Let’s say these cards are a Chase Card with a balance of $4000, a Citibank card with a balance of $5,000, and a Discover card with a balance of $6,000. Let’s assume, for the sake of simplicity, that the Chase card has a monthly minimum payment of $70, Citi is $105 and Discover is $130. 

You’ll make the minimum payments on the Discover and Citi cards. For the Chase card, you’ll pay not only the minimum payment, but dedicate any extra money you have from your savings and side gigs, towards paying down the account.  Let’s say you earn $300 a month from your other employment. You will apply that money towards paying down the Chase card. This way, what you owe on the Chase card will be paid down more quickly.

Once that is done, you’ve succesfully paid off the Chase account. You’ll now apply everything you were paying towards Chase, as well as the minimum payment you were already making on the Citibank account, towards paying down your Citi card. 

Next, you’ll move on to Discover, applying everything you were paying towards Citi, plus the minimum payment on the Discover account. This approach takes work and patience. However, it will preserve your credit score, and allow you to reduce debts on your own, without the fees of a debt relief or debt management company. If you choose to go this route, you’ll want to 

The Debt Avalanche Method

The debt avalanche method involves paying down debts in order of interest rate. First, you’ll take a look at each of your credit cards, and see what is the exact interest rate you are paying. Next, you’ll review your monthly income and expenses. Just as with the debt snowball method, you’ll also consider whether it is possible to take on some sort of side work, which allows you to supplement your income.

Let’s return to our example of cards from Chase, Citi and Discover, with balances of $4,000, $5,000 and $6,000. However, this time let’s assume that Chase has an interest read of 14.3%, while Citi charges 15.1%, and Discover charges 12.1%. 

You will want to make the minimum payments on every card, except for the one with the highest interest rate. On that card, you’ll pay the minimum payment, plus any extra savings you have. 

The reasoning behind this is that the card with the highest interest rate is costing you the most, in terms of how the balance continues to grow. By paying this card down faster, you’ll get out of debt more smoothly, i.e. by spending less. 

In this case, that means you would work on paying off the Citi credit card first. After that, you’ll apply all the money from paying that card, towards the Chase card (which has the next highest interest rate). Then, you’ll focus on Discover. 

As with the debt snowball method, this approach takes time. However, you’ll enjoy the satisfaction of having paid your debt yourself, and you’ll be able to preserve your credit score.  

Bankruptcy

The final option to consider is filing bankruptcy.  In a bankruptcy filing, you are telling a court that you are incapable of meeting your current debt obligations. The court will then seek to liquidate your assets (if any) to repay your debts. Some of your property might be exempt. 

The types of debt discharged (that is, gotten rid of) through bankruptcy varies as well. Student loans, for example, are relatively hard to discharge in bankruptcy, while credit card debts tend to be somewhat simpler. 

Bankruptcy is not something you qualify for automatically. With Chapter 7 bankruptcies (the most common type of filing), you are also subject to a means test, which makes sure you are using the bankruptcy process properly, and not engaging in manipulation or abuse.

After you file and discharge a bankruptcy (that is, have all of your debts processed, and the payment amounts to each creditor determined), the bankruptcy will now appear on your credit report. This will initially mean a substantial hit to your credit score, and will probably stop you from purchasing a home, for at least 2 years. 

However, it is very much possible for you to rebuild your credit score, and to get yourself back into a good position over the next few years. Many people enjoy a FICO score in the high 600’s (or even higher) just a few years after bankruptcy. If you are facing very severe debts, bankruptcy can help you reset, and get back on track.  

The Final Word

Getting out of debt can be a very challenging, confusing process. It isn’t easy to understand what the best approach is. 

Debt relief can be a good option for some, but it can also do major damage to your credit. There is also no guarantee it works effectively – many credit card issuers choose not to work with you. 

As you can see, there are many alternatives to debt relief, and most of them are less damaging to your FICO score. Figure out what works best for you, and start building a new life, without the stress of uncontrollable debt.