How does debt relief work?

With the cost of living continuing to grow, many people find themselves grappling with insurmountable levels of debt. In fact, the average household in America carries around $104,215 in debt.¹ When all other options have been exhausted, debt relief can be the next best step. Here, we look at what it is and how it works.

Debt relief provides respite from the relentless cycle of paying back debt. The goal is to make it easier for borrowers to repay what they owe and ultimately become debt-free.

There are various options for debt relief, such as:

• Reducing the total amount of debt
• Lowering the debt’s interest rate
• Extending payment timelines
• Consolidating multiple debts into one easily repayable loan
• Negotiating with creditors to settle for less than the full amount of money they owe.

Debt relief isn’t new; it has been around for centuries, helping not just individuals, but also businesses and even countries. These days, it’s designed to make debt manageable, so people can make a fresh start and use their money as they wish.

So how does debt relief work, exactly, and where do borrowers seek advice? The first step is usually to create a plan, and various professionals can help you with that.

Debt relief plans often appeal to those feeling overwhelmed by their financial situation; they see no way to pay off their debts in the next few years, and need some outside assistance.

So what’s in it for the creditor? Well, creditors are often more willing to negotiate when they see that the borrower is actively trying to manage their debt. After all, it’s in their best interest to recover some money rather than risk the borrower defaulting entirely.

If it’s simple advice you’re after, credit counseling agencies can be a starting point - they often offer services for free or at a low cost. More drastic options include debt settlement companies that use riskier strategies to negotiate a lower total debt.

Credit counseling is a financial service aimed at helping anyone who feels overwhelmed by debt. Its primary goal is to guide you through debt repayment strategies and help you avoid bankruptcy. Often provided by non-profit organizations, many credit counseling services come at no cost, although this can vary by state.

A certified credit counselor will take a close look at your financial situation, including your debts, credit, and budget. Based on this assessment, they’ll suggest the best steps to take next.

If your debt is the result of a pattern of bad habits that have built up over time, credit counselors can also help you learn how to budget your money and improve your personal money management skills. The main aim is to prevent you getting into debt in the first place.

Aside from debt repayment, credit counseling can support various aspects of your financial health, so it can also help if you’re considering buying a home or planning for retirement.

Credit counseling agencies can also help you set up a debt management plan (DMP). This plan rolls all your unsecured debts (like credit cards and personal loans) into one monthly payment. So instead of multiple payments, you’ll only need to make one payment to your credit counseling agency. They handle the rest, ensuring your payments go to the right places on time.

One of the benefits of a debt management plan is that some counselors can negotiate directly with your creditors. They may be able to secure lower interest rates or even get fees waived, making it easier for you to pay off your debts.

If you’ve racked up several different debts and are struggling to keep up with the monthly payments, debt consolidation is another debt relief option to consider.

Similar to debt management plans, this strategy combines multiple debts into a single loan with one monthly payment. Here, though, you take out a new loan to pay off all your debts. This is often a personal loan, as the interest rates are usually lower than credit card APRs.

While debt consolidation doesn’t reduce the total amount of money you owe, it makes the repayment process easier and can help speed up the path to becoming debt-free. In some cases, you might even secure a lower interest rate, especially if you have good credit.

Debt settlement is a form of debt relief where you and a creditor agree to settle a debt for less than what you owe. This can mean either reducing the total amount or lowering the interest rate in exchange for a lump-sum payment. Debt settlement companies do the work for you, but they typically charge fees based on the amount they save you.

The process usually takes three to four years. First, you’ll need to build up enough funds in a settlement account. During that time, the settlement company negotiates with your creditors to reach agreements.

The basic idea behind debt settlement is that creditors might accept less than what you owe if they see you’re not making payments. Instead of paying your debts directly, you make payments to the settlement firm, which handles negotiations and, if successful, pays your creditors.

Debt settlement can be one of the riskier debt relief options. While the idea is to stop paying your debts as a negotiating tactic to score better terms, it can backfire. You might find yourself facing relentless debt collection companies, or worse, winding up in court if negotiations don’t pan out.

Plus, debt settlement tends to attract companies claiming they can resolve people’s debt but ultimately leaving them worse off. During the time you’re not making repayments, interest on your debts could skyrocket, and there’s no guarantee that this approach will actually succeed.

Here are a few more drawbacks:

• Many debt settlement companies charge fees ranging between 15% to 25% of the settled amount, which can eat into any savings you hoped to gain.
• Settling your debts can have a negative impact on your credit score, making it harder to get loans or favorable rates in the future.
• Some debt settlement companies may require you to set aside money in a dedicated account during negotiations, which means those funds are off-limits, leaving you with less disposable income.
• Any forgiven debt may be considered taxable income, potentially leading to unexpected tax bills later on.

Yes, but it’s often viewed as a last resort after all other options have been explored. Filing for bankruptcy can provide immediate relief by stopping creditors from pursuing their debt collection efforts. When you file, the court issues an automatic stay, which halts actions like wage garnishments, lawsuits, and constant calls from creditors. This can be a huge emotional and mental relief for many people.

There are two main types of bankruptcy: Chapter 7 and Chapter 13. Chapter 7 is faster, typically wiping out most unsecured debts within three to four months. However, it doesn’t cover all debts, and it can severely impact your credit score for years. Chapter 13 allows you to keep more of your assets and, if you successfully complete the plan, any remaining unsecured debts might be forgiven.

If you’re grappling with multiple high-interest debts, a debt relief program might be a good way to lighten the burden and get you debt-free faster. These programs offer a clear plan to help you get back on track. Credit counselors, in particular, provide a hands-on, holistic approach that can address the root cause of your debt problems.

It’s also worth considering whether yours is good or bad debt. Debt relief programs typically target unsecured debts, like credit card bills and personal loans - the “bad” type. However, they usually don’t apply to secured (“good”) debts - such as mortgages and car loans, because those debts are tied to specific assets.

And if you’re able to manage your debt on your own, you might not need to rely on debt relief plans in the first place. It could be worth trying a DIY approach first. As a first step, you might get in touch with your creditors to negotiate better terms yourself. You could also try a budgeting method, like the 50/30/20 rule, to help allocate your income more effectively.

If you are managing your debt fairly well, debt payoff plans like the debt avalanche or snowball methods can help you pay off what you owe consistently. These approaches focus on paying down debts efficiently and can be just as effective as formal debt relief.

When considering debt relief, one important factor is your debt-to-income ratio - how much of your monthly income goes toward debt payments. When debt starts to make up a significant portion of your income, say, 40% to 50%, some consider this the point to start looking into an initial consultation with a credit counseling agency.

However, keep in mind the following:

Debt relief can affect your credit score, but it’s not always as bad as it sounds. In fact, depending on the program you choose, it might even help improve your credit over time. For instance, while debt settlement could lower your score initially, some people find it’s worth the trade-off. However, if you’re still able to make your monthly payments or haven’t explored other options like debt management or consolidation, debt settlement might not be the best choice for you.

To avoid scams, it is generally recommended to seek out agencies certified by the National Foundation for Credit Counseling or the Financial Counseling Association of America. It is worth checking that they clearly state what types of debt they handle and are upfront about any fees. Be cautious of companies that make unrealistic promises or claim to offer services they can’t deliver.

Any forgiven debt may be considered taxable income, meaning you could end up with a bigger tax bill. What’s more, working with a debt relief company comes with fees, which could make your money situation even more critical if you’re already struggling financially.

After getting a handle on your debt, the next step is to give yourself a solid financial footing for the future. A high-interest savings account can help you grow your savings faster and give you a financial buffer to help protect against any future money issues. With Raisin, you can access competitive interest rates across savings accounts, high-yield CDs and no-penalty CDs. See how much you could earn on your money!

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

¹ https://www.businessinsider.com/personal-finance/credit-score/average-american-debt