Understanding Debt Relief Programs

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Nobody seeks out illness, job loss, divorce or any other financial catastrophe, but sometimes things happen. Many people will accumulate overwhelming debt loads as a result of such hardship. If the burden of your debt is too much for you to afford, what can you do? The worst thing to do is jump into a debt relief program without educating yourself.

In this guide, we’ll explain the risks and benefits of the most common types of debt relief programs.

Bankruptcy

Chapter 7 bankruptcy, also known as liquidation bankruptcy, offers comprehensive debt relief. In liquidation bankruptcy, a court-appointed bankruptcy trustee sells certain assets (called unprotected assets), and the proceeds are used by the trustee to repay your creditors. Following the distribution of funds, the court discharges the remaining eligible debts. That means you no longer owe the debt and collectors cannot contact you about the debt. Debts that the court won’t discharge include: income tax debt that’s less than three years old, child support or alimony payments, student loans and fees and penalties owed to the government.

Although Chapter 7 bankruptcy requires selling off your valuables, filing may not leave you penniless. Filers can keep protected assets, such as personal items and money in retirement accounts. Most states allow filers to keep a small amount of cash and some amount of equity in vehicles or homes.

Who is a good candidate for Chapter 7 bankruptcy?

Chapter 7 bankruptcy is available to anyone earning less than the median monthly income for a family of your size in your state. If you earn more than the median income, you may qualify for Chapter 7 bankruptcy through “means testing.” The means test shows whether you have enough income to cover a debt repayment plan that Chapter 13 bankruptcy requires.

Being eligible for Chapter 7 bankruptcy doesn’t mean it’s a good idea for you. Some people have too many unprotected assets to make Chapter 7 bankruptcy a reasonable option. Chapter 7 bankruptcy may force people into selling paid off cars, tools for operating their business or other important assets. In those cases, Chapter 13 bankruptcy or other types of debt relief may be a better option.

— Read our article on when to consider bankruptcy

How much will you pay for Chapter 7 bankruptcy?

The amount you’ll pay for Chapter 7 bankruptcy depends on a variety of factors, including where you live and the complexity of your case.

You can expect to pay $1,100-$1,200* in attorney’s fees when you file Chapter 7 bankruptcy, according to Lois R. Lupica’s Consumer Bankruptcy Fee Study. Filers must also pay filing and court fees, which adds several hundred dollars to the cost of bankruptcy. In general, all fees have to be paid before your attorney will file your case.

*Numbers adjusted for inflation.

How does bankruptcy affect your credit score?

Following bankruptcy, your credit score will drop, but it’s not necessarily a death sentence. Bankruptcy stays on your credit report for 10 years after filing, but your credit score can recover. You can take steps to grow your credit score immediately following Chapter 7 bankruptcy.

In some cases, bankruptcy filers choose to reaffirm debts as part of the bankruptcy agreement. That means they agree to continue paying certain loans (such as a car loan or mortgage) as agreed. Making those payments can increase your credit score over time. Making timely payments on a secured credit card can also help you rebuild your score.

Filing for bankruptcy becomes less significant as time passes and you continue to display positive financial management on your credit report.

Risks of bankruptcy

  • Lower credit score: Following bankruptcy, you can expect to see your credit score drop. The lower score may make borrowing inaccessible for several years.
  • Can’t take out a mortgage: Bankruptcy makes you ineligible to take out most mortgages. Following bankruptcy, you’ll have to wait two years to take out an FHA mortgage and four years for a conventional mortgage. — Read how to get a mortgage after bankruptcy here.
  • Loss of property: Chapter 7 bankruptcy means you may have to sell off assets, which could put you in a precarious financial situation. “In Florida, you only get a $1,000 vehicle allowance. The fact that you need a vehicle to get to and from work isn’t factored into the equation,” Shawn Yesner, a bankruptcy and debt relief attorney practicing in the Tampa Bay area, told MagnifyMoney.
  • Problems with professional licensing:Leslie Tayne, a debt management attorney practicing in the New York City and Long Island area, helps clients avoid bankruptcy through debt settlement. Many of her clients are financial professionals who could face trouble renewing their license if they filed bankruptcy. “In cases like that,” Tayne told MagnifyMoney, “the last thing you want is to file bankruptcy. Something happened that caused this person to get in over their head, but they shouldn’t lose their livelihood because of it.”

Benefits of bankruptcy

  • Automatic stay: The courts grant all bankruptcy filers an automatic stay against collections activities. This means that all collections activity against you has to stop right away.
  • Discharge most debts: People with very few assets (or only protected assets), can expect to have eligible debts discharged without paying anything except attorney’s fees and filing fees.
  • Quick resolution: On average, Chapter 7 bankruptcy resolves within 115 days. Within a few months of filing bankruptcy, you can expect to move on with your life.

Other types of bankruptcy

Aside from Chapter 7 bankruptcy, many consumers file Chapter 13 bankruptcy. Chapter 13 bankruptcy allows you to keep all of your assets, but it comes with a downside. Chapter 13 bankruptcy involves a debt payment plan that lasts three to five years. On top of that, the fees for Chapter 13 bankruptcy can be much higher than the fees for Chapter 7 bankruptcy.

6 things to do before filing for bankruptcy

  1. Talk to a lawyer for free: Before deciding to file bankruptcy, talk with a few bankruptcy attorneys. Many bankruptcy attorneys offer a free consultation to determine your eligibility and give you estimates of the fees.
  2. Explore alternatives: Bankruptcy is one option, but it’s not always the best choice. Before committing to bankruptcy, you may want to talk with a certified credit counselor about other options.
  3. Understand the costs: You’ll need to come up with $1,000 or more to pay for your bankruptcy fees.
  4. Find low-cost help: In some counties, you may be able to find free or low-cost legal help through Legal Aid.
  5. You can’t declare bankruptcy again for eight years: Bankruptcy is a form of last resort for debt relief. If you opt to declare Chapter 7 bankruptcy, you won’t be able to declare bankruptcy again for another eight years.
  6. Discharged debt is taxable: Bankruptcy may relieve you of your debts, but you will have to pay income tax on the amount of debt that is discharged. You may owe the IRS more than usual when you file taxes at the end of the year.

— Read our guide on when to file bankruptcy

Debt management plans

A debt management plan is a new payment schedule for paying off existing debts. These plans are created and administered by nonprofit credit counseling companies. Under the plan, credit counselors will consolidate your credit card debts, unsecured personal loans and bills in collections into a single, monthly payment. You’ll pay the credit counseling agency instead of paying creditors directly.

The credit counseling agency doesn’t just consolidate debt, it works to reduce your monthly payment. The agency may be able to reduce interest charges, get old fees waived and even extend the length of time you have to pay a loan. “Most of the time, people see smaller monthly payments when they go on a debt management plan,” said Robby Dunn, vice president of counseling at the nonprofit company, Consumer Credit Counseling Service of Buffalo.

What happens to credit cards?

In general, when you agree to a debt management plan, your creditors close down your lines of credit. This means that you cannot use your credit cards during the repayment plan. Dunn told MagnifyMoney that some people keep one credit card with a low balance off the debt management plan. This allows people to keep a source of credit available for emergencies.

Will a debt management plan help my credit score?

When you start a debt management plan, you’ll have to close every credit card account you have, even accounts that are in good standing. This reduces your length of credit history and results in an immediate drop in your credit score; however, most people can regain the lost points in six to twelve months.

What happens if I miss a payment?

It’s imperative that you stick to your repayment plan and don’t miss any payments. Your credit counseling agency won’t be able to pay your creditors if you don’t pay them, which doesn’t leave you with many good options. “It’s important to understand that your creditors aren’t likely to be empathetic toward you. They expect to get paid,” said Dunn.

Creditors that don’t get paid may drop out of the debt management plan and report that you’re no longer paying as agreed. The creditors may also attempt to collect your debts through other means.

Risks of debt management plans

  • Debts not reduced: Unlike other forms of debt relief, debt management plans don’t reduce the amount you owe. Instead, these plans reduce your interest charges and fees.
  • Difficulty getting new credit: Closing your current credit accounts may lead to a short-term drop in your credit score. On top of that, lenders may see that you’re repaying your debts through a credit counseling agency, which may affect their willingness to extend various types of credit.
  • Lower credit score: The goal of a debt management plan is to help you clear debt without declaring bankruptcy. Unfortunately, the plan may yield a lower credit score when you close down so many accounts.

Benefits of debt management plans

  • Lower fees: Compared with bankruptcy or debt settlement, debt management plans are a low-fee option. Traditionally, nonprofit companies charge a small setup fee (less than $100 in general) and a monthly service charge ranging from $25-$50. The CFPB recommends asking credit counseling companies about setup or monthly fees before you work with the company.
  • Avoid bankruptcy: By sticking with your debt management plan and making the agreed-upon monthly payments, you can avoid bankruptcy and pay off the full balance of your debt.
  • Reduce monthly payments: The debt management plan generally comes with lower monthly payments.

Things to know before accepting a debt management plan

  • How long the plan takes: Clearing all your debts through a debt management plan could take as long as five years. A credit counselor can walk you through the specific length of your debt payoff plan.
  • No debt forgiveness: Credit counselors don’t negotiate for loan balance reductions. Even on a debt management plan, you’ll still owe the balance of your debt and interest charges.
  • Work with a nonprofit: For-profit debt management companies generally charge higher fees than nonprofit companies. You can find certified nonprofit financial counselors from the Financial Counseling Association of America (FCAA) or the National Foundation for Credit Counseling (NFCC).
  • Credit counselors help you consider other options: Debt management plans are important tools offered by credit counselors, but they shouldn’t be the only option. “Our main goal is to educate clients on what their options are. We try to help them see the advantages and disadvantages of each option,” explained Dunn.

Debt settlement

Many people confuse nonprofit credit counseling companies with for-profit debt settlement companies. Debt settlement companies do not offer credit counseling services, and instead, work to help you pay off debts that are already in collections.

How does debt settlement work?

When you settle a debt, you agree to pay a creditor a portion of the debt you owe. In exchange, the creditor won’t sue you for the remaining balance. Most of the time debt settlement companies can only help you settle the debt that’s in collections.

Debt settlement companies will negotiate with creditors on your behalf. Although these companies work for you, the amount you ultimately pay depends on the creditor, your income, how long you’ve owed the debt and the type of debt you owe.

For example, credit card lenders may be more willing to settle your debts than business lenders. Additionally, debt settlement attorneys may be able to reduce the amount you owe on private student loans, but that’s not possible with federal student loans. Yesner estimates that most credit card companies settle for an average of 30%-35% of the debt amount owed, but he’s quick to point out that the range varies widely case to case.

It’s a good idea to have a solid understanding of the debt settlement process before you start working with a debt settlement company or attorney. If you don’t have upfront cash savings — a requirement for some companies — they may want you to set up a dedicated savings account to pay fees and funds. Legally you will own the funds in this account and have complete control over the account at all times.

Other companies may be willing to work with you to negotiate new payment plans. Tayne explained that she negotiates installment plans on behalf of her clients. Through her negotiations, she aims to reduce the interest rates to 0% and reduce the principal balance to a manageable amount; however, that’s not always possible to achieve.

Debt settlement companies may also ask you to change how you’re handling your creditors. If you’re paying debts as agreed, a debt settlement company may advise you to stop paying your debts.

How are debt settlement companies paid?

The fee structure of a debt settlement attorney or company will heavily affect your overall costs. “You only want an attorney that works on contingency. They should be compensated based on how much money they save you,” Tayne said. Contingency fees (fees based on a percentage of savings) incentivize your attorney to negotiate the amount you owe as low as they can. If the fee isn’t based on a negotiated savings rate, it will be based on a percentage of your overall debt load prior to negotiations.

Debt settlement companies cannot legally charge you any money unless they have successfully negotiated at least one debt for you. You must pay your creditor before the debt settlement company can collect its fee.

How does debt settlement affect my credit score?

There’s no doubt that settling your debts will affect your credit score; however, exactly how much it affects your score is difficult to estimate. Once an account is in collections, settling the debt will not cause any further damage to your credit score. However, defaulting on an account that’s on a debt settlement plan could cause substantial harm to your credit score.

“In most cases, [your credit score] will go down, but it won’t go down permanently. In some cases, settling debts could actually raise your credit score. If you have a score in the low 600s with all your accounts in default, you might see it go up right away,” said Tayne.

Risks of debt settlement

  • Legal risks: Your creditors may sue you if you default on your debts.
  • Debt load could grow: When you default on your debts, your creditors may charge you late fees or higher interest rates. Even when working toward settling a debt, your total debt balance could still grow.
  • No guarantees: Most of the time, debt settlement companies don’t have prearranged agreements with your creditors. That means that the company cannot tell you how much you’ll ultimately owe, nor can they tell you how long the settlement process will last.
  • Amount forgiven is taxable: When you settle a debt for less than you owe, the IRS considers the forgiven amount income. That means you’ll pay state and federal income tax on the forgiven amount (in most cases).

Benefits of debt settlement

  • Reduce the amount you owe: When you settle a debt in collections, you’ll only pay a percentage of what you originally owed.
  • Avoid bankruptcy: Settling debts can keep you out of bankruptcy courts. Negative information will remain on your credit report for seven years, but your credit score may recover more quickly from debt settlement than bankruptcy.
  • No fees without successful negotiation: It is illegal for debt settlement companies to charge you a fee if they fail to change the terms of your debt. You’ll only pay if the company negotiates your debt.

What are the risks to not paying creditors?

Strategically defaulting on debt may sound reasonable, but it can expose you up to a variety of risks. When you stop paying your bills, your creditor may charge you higher fees and interest. If you can’t successfully settle the debt, you’ll owe more than you did before.

Defaulting on debt will lead to negative marks on your credit report. Negative information will stay on your credit report for seven years. Settling already-defaulted debt won’t harm your credit any further; however, defaulting on a current debt account could cause your credit score to take a big hit.

Finally, your creditors may sue you if you default on a debt. Due to legal risks, Tayne recommends working with a debt settlement attorney rather than a debt settlement company. “You need someone who understands how to handle the legal risks appropriately,” she said. “It’s not enough for a company to say ‘We have an attorney on staff.’ It’s better to know that an attorney will handle legal matters.”

Things to know before settling debt

  • How are fees determined: Debt settlement companies can collect fees using two methods; they can charge you a percentage of your total debt load, or they can charge based on a percentage of savings.
  • You won’t get any guarantees: Debt settlement companies cannot promise you how long the negotiations will take, nor can they guarantee the settlement amount. Representatives offering promises are engaging in illegal activity and you should not work with them.
  • Creditors could sue you: If you fail to make payments as agreed, a creditor could sue you. After a creditor wins a suit against you, they can collect a judgment against you, which could include garnishing your wages or putting a lien on your property.
  • Creditors may offer standard settlements: Some creditors have adopted standard policies about settling debts in collections. You may be able to settle your debts on your own.

Can I settle debt on my own?

Creditors may be more willing to work with individuals than debt settlement companies, but settling debts on your own presents its own risks.

The CFPB sets out a three-step process for negotiating settlements with your creditors. The process recommends understanding your debts, proposing a solution and negotiating a realistic agreement. During the final step, the CFPB recommends enlisting the help of an attorney or credit counselor to help you with the negotiations. “Settling a debt sounds simple; you simply call up a creditor and work out a settlement. In reality, it can be a lot of work. It can take three or four hours just to start talking with the right person,” explained Tayne.

“You’re probably smart enough to do this on your own. The real value that I bring is that I do this day in and day out. Sometimes it’s just more efficient to pay someone else,” added Yesner.

That said, if money is tight, settling debts on your own could be the right option for you. Below we explain how to work through your own debt relief program.

DIY debt relief

Making your own debt relief plan may seem overwhelming, but it is possible to find debt relief without paying for outside help. Use the following tips to be successful with your own debt relief plan.

Put a stop to creditor harassment

A DIY debt relief plan requires executing a well-thought-out plan. This isn’t easy if you’re constantly hounded by calls from debt collectors. Put a stop to creditor harassment instead of sending your money to the most threatening collector.

The CFPB provides sample letters that can help you deal with debt collectors. These letters can stipulate when and how a debt collector can contact you. While collectors can still sue you, they cannot legally contact you.

Know what you owe

Once you have the creditors at bay, the first step in resolving your debt is knowing what you owe. Specifically, you will need to know how much money you owe, who owns the debt, the interest rate on the debt, the minimum monthly payment on the debt and whether the debt is in good standing. You can find most of this information from your credit report (which you can get for free from AnnualCreditReport.com).

You can find the exact amount you owe and the interest rate on current debts from the most recent billing statements from your lenders.

Make a plan for “good standing” debt

Debts in collections may seem like the most pressing matter, but most of the time you’ll want to deal with current accounts first. Once a debt is in collections, it has already damaged your credit score. Only time (and adding good credit information to your report) will fix the damage.

Unless a creditor sues you, you’ll want to put your money toward debt that’s still in good standing before dealing with debts in collections. This guide offers step-by-step guidance on how to eliminate credit card debt as fast as possible.

It’s important to note that dealing with current debts isn’t always a matter of making minimum payments on all your loans. If you have student loans, you may want to consider opting into an income-driven repayment plan. These plans will reduce your monthly payments, so you can put more money toward high-interest credit card debts.

For credit card debts, unpaid medical bills and other related debts, you may want to consider a debt consolidation loan. Debt consolidation loans are unsecured personal loans with fixed interest rates and fixed repayment schedules. They allow you to roll all your payments into a single payment, reduce your interest rate and (in some cases) increase your credit score.

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Settle debts in collections

Once you’ve paid off your debts that are in good standing (or you’re easily able to make your monthly payments), you may want to work toward paying off bills in collections. Paying off bills in collections won’t improve your credit score, but it can help you avoid lawsuits.

Before you reach out to your creditors, you’ll want to create a budget that shows you how much you can put toward debt that’s in collections each month. A certified credit counselor could help you create a budget if you need help. A credit counselor or a consumer advocacy attorney may also be able to advise you if the statute of limitations on your debt has expired. When the statute of limitations on debt expires, debt collectors can no longer sue you to collect.

If you determine that you still want to pay off your debt in collections, you can propose your payoff plan to your creditor. Do not put any money toward debts in collections unless you get a payoff agreement in writing.

Enlist help as needed

Although a DIY debt relief plan is a low-cost way to get rid of debt, you may need help. If a creditor or debt collector sues you, you’ll want to contact a consumer advocacy attorney. Don’t ignore lawsuits, or your creditor may win a judgment against you.

Additionally, credit counselors that work for nonprofit companies may be able to help you understand your best options, such as through the FCAA or NFCC.

Watch out for debt relief scams

If you choose to work through overwhelming debts on your own, you could run into some scams. The following are red flags that someone or some company might be trying to scam you:

  • Charging advance fees for debt settlement: Debt settlement companies cannot charge you any fees unless they successfully help you settle a debt. Do not work with a debt settlement company that charges upfront fees.
  • For-profit credit counseling: The vast majority of credit counseling companies are not for-profit companies. The nonprofit status allows credit counselors to consider a range of payoff options instead of pushing clients toward solutions that help the company maintain the highest profits. Generally, it’s more beneficial to work with nonprofit credit counseling companies than for-profit credit counseling companies.
  • Companies making guarantees: Do not work with any company that makes guarantees or promises about debt relief. Whether you’re trying to settle debts, declare bankruptcy or reduce your monthly payments, a company cannot promise that your creditors will work with them. The best a company can do is determine whether you’re a good candidate for their services.
  • Pushy companies: No single debt relief plan is perfect for everyone. Don’t work with companies that push one option without helping you understand why that option is best for you, while also providing you with alternatives.

What to avoid when facing overwhelming debt

  • Sending money to the loudest collection agency: A good debt payoff plan deals with current debts before dealing with debts in collections. Do not send money to the debt collectors because they harass you. Instead, use a written request that tells the collector when and how they can contact you.
  • Ignoring lawsuits: Contact a lawyer who can help you understand the best options for your situation if you receive notice of a debt collection lawsuit. Ignoring the lawsuit won’t make it go away, and could make your financial situation worse.
  • Making partial payments: If you don’t have the money to pay all your monthly bills, don’t make matters worse by sending partial payments to all your creditors. Partial payments are considered just as bad as not sending a payment at all. Instead, send full payments to as many creditors as possible to keep more debts out of collections and help you rebuild your credit score.

The bottom line: When should you consider debt relief?

If you’re struggling to make your monthly debt payments, or you’re overwhelmed by calls from collection agents, you’re a good candidate for some sort of debt relief. Seeking advice from a bankruptcy attorney or a certified credit counselor is a good place to start. When you know more about your debt relief options, you can make a plan to get back on track financially.

Even if you’re making on-time payments on most of your debts, you may still benefit from a debt relief plan. Those with debts in good standing may find relief from debt management plans, consolidating your debts or by taking advantage of promotional balance transfers.

Whether you’re struggling to make payments, or you’ve already defaulted on your debts, debt relief could be right for you. The sooner you start your research, the sooner you’ll get yourself back on the right financial foot.

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Hannah Rounds
Hannah Rounds |

Hannah Rounds is a writer at MagnifyMoney. You can email Hannah here

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