Debt Relief: 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.

Find that you're just not making progress on your debt, no matter how hard you try? If that's the case, you might be facing overwhelming debt.

To break free of this financial burden, look into your debt relief options. These tools can change the terms or amount of your debt so you can get back on your feet more quickly.

But debt-relief programs are not the right solution for everyone, and it’s important to understand what the consequences might be.

Debt relief could involve wiping the debt out altogether in bankruptcy; getting changes in your interest rate or payment schedule to lower your payments; or persuading creditors to agree to accept less than the full amount owed.

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.

Beware: Debt relief can make things worse

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 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.

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. We recommend talking with a bankruptcy attorney first, before you pursue any debt relief strategy. 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 decimate your credit scores and stay on your credit report for up to 10 years even as you restore your credit history. That’s no small thing, because poor credit history can affect your eligibility for certain jobs, your chances of getting an apartment lease, and how much you pay for car insurance. When your credit is already bad, a bankruptcy may allow you to rebuild your credit much sooner than continuing to try to repay.
• 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 motor vehicles up to a given value and part of the equity in your home, but you usually have to give up a second car or truck, family heirlooms, vacation homes and any valuable collections.
• 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. The creditors can still sue you and get a judgment, but they won’t be able to collect.

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. It will take longer than a Chapter 7 — but 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.

Relief through debt management plans

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

Relief through debt settlement

Debt settlement is a financial game of chicken. We do not recommend debt settlement for the vast majority of people. Bankruptcy is almost always a better option; debt settlement is a last resort for those who face overwhelming debt but cannot qualify for bankruptcy.

Debt settlement companies typically ask you to stop paying your creditors and instead put the money in an account they control. Each creditor is approached as the money accumulates in your account and you fall further and 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.

Not paying your bills can result in collections calls, penalty fees and, potentially, legal action against you. Debt settlement stops none of that while you're still negotiating. Expect at least four to six months before the settlement offers 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). Lawsuits can lead to wage garnishments and property liens.

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 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.

Do-it-yourself debt relief

There’s nothing to say you can’t borrow from some of the above-listed debt relief options and create your own plan.

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.

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 apply for a credit card with a 0% balance transfer offer that can give you some breathing room. Or you may find a debt consolidation loan with a lower interest rate.

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 that will prevent you from running up your credit card debt again. It also can be hard to qualify for a new card or loan when you are deeply in debt, because that often leads to missed payments or high balances, and those hurt your credit standing.

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 pay a secured debt (like a car payment) late in order to pay an unsecured one (like a hospital bill or credit card). You could lose the collateral that secures that debt (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 is financial suicide.
• 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; that may lead to actions that aren’t in your best interest. Instead, take time to research your options and choose the best one for your situation.