Are you struggling with debt? If so, this blog post is for you. We want to help you understand all the different ways to get out of debt and determine which is the best way to get out of debt for you.
Believe it or not, there are many unreliable and even predatory companies out there that will take advantage of you if you’re not careful, so you must do your research and understand how these options work and decide which get-out-of-debt method is right for you.
Below, you’ll find concise explanations of the five major ways that Americans get out of debt:
- Debt Consolidation
- Debt Management
- Debt Settlement
- “Do It Yourself”
We’ve found that using traditional methods to search for information about these programs doesn’t work. For example, if you use a search engine like Google to look up information about debt settlement or debt consolidation, you’ll likely come across many unsavory companies trying to lure you into their clutches before you stumble upon any reliable explanation of how the process works.
Because of that, you can end up making a decision that puts your financial situation at greater risk.
So before you get caught up in paying thousands of dollars to a company that’s not trustworthy, read through the information below and learn what you need to know about the most common ways to get out of debt.
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What Is Debt Consolidation and How Does It Work?
Of all the options available to people who need debt help, debt consolidation is one of the most mild, least drastic options. That’s because, unlike other methods we’ll describe below, you don’t have to negotiate with your creditors in order to do debt consolidation.
Debt consolidation entails taking out a new loan (called a debt consolidation loan) to pay off your existing debts. The term “consolidate” means to group several things together into one, which makes sense, since debt consolidation groups all your existing debts into a new loan. This helps to streamline your payments – you’ll pay just one bill every month instead of many.
It can also allow you to get a lower interest rate and lower monthly payments than what you’re currently paying.
Here is what to expect if you choose to get a debt consolidation loan:
1. You contact a bank or peer-to-peer lender. First, you do some research to identify which company you want to work with. (If you need help with this, read How to Find a Reputable Debt Consolidation Company or learn about specific debt consolidation programs) After you get in touch with a lender and verify that their terms and interest rates are good, you’ll need to allow them to check your credit score. If it is above 660, you should be able to get a consolidation loan.
2. You work with the lender to set terms for your new loan. Since the bank or peer-to-peer lender who is offering the debt consolidation loan will be your new (and only) creditor, you need to work with them to ensure the interest rate and monthly payments are going to work for you. As always, read the fine print. And don’t forget to calculate the total cost of the loan (including all the interest you will pay).
3. Your debts are transferred to the new lender. Once this happens, you no longer owe your previous creditors anything. You now owe the new lender the total amount of your balance.
The Bottom Line:
If you want a different repayment plan than what you’ve currently got – one that works better for you (with lower interest rates, etc.) then debt consolidation is a good option.
As always, make sure you work with a company that you trust and don’t sign up for a repayment plan that is unrealistic because you don’t want to end up making late payments or getting swallowed up by debt again if you’re not able to stick to your plan.
For more details about debt consolidation, check out these blog posts:
- How Does Debt Consolidation Work?
- Does Debt Consolidation Hurt Your Credit?
- Is Debt Consolidation a Good Idea?
What Is Debt Management and How Does it Work?
Of course, debt consolidation is not the only way to get out of debt. Another common method is debt management. These two terms are often mixed up, because many companies advertise both debt management and debt consolidation.
In reality, debt consolidation only refers to getting a new loan that pays off your old debts and gives you one payment.
On the other hand, a debt management plan (DMP) is a program offered by companies or non-profit groups that helps you negotiate a new payment plan with your current creditors. So unlike debt consolidation, you still have the same debts (with the same balances) but you negotiate for lower interest rates and, if necessary, lower monthly payments.
People usually go to a “credit counseling” non-profit organization to get help starting a debt management plan. (There are also for-profit companies that do debt management) If you decide to do debt management, it’s best to use a certified credit counselor.
Here are the steps you can expect to go through if you do a DMP:
1. You make an appointment with a credit counselor. At this meeting, you will go over your entire financial picture and the credit counselor will try to give you practical ways of improving your monthly budgeting so that you’ll have money leftover to pay off your debt.
2. They help you make a plan for paying it off. Based on the number of accounts you owe, and your ability to make monthly payments, they will create a debt management plan that’s tailored to your situation. To do this, they will communicate with your creditors and ask them to lower your interest rates and your monthly payments.
3. Your credit cards are canceled and you begin the plan. Depending on which organization you work with, you may be asked to use a direct deposit program to pay your monthly amount. Since your credit cards will be canceled, you’ll need to be prepared to for life without credit – and your credit score may be temporarily hurt because the canceled cards will increase your rate of credit utilization.
4. The DMP usually takes 3 to 6 years to complete. Of course, the timeline depends on your total debt and how much income you’re directing toward getting out of debt. If you finish the DMP, you should have no remaining debt obligations, and, although your credit score may be lower, it will better than if you had gone through bankruptcy or debt settlement.
The Bottom Line:
You should only do debt management if you are having trouble paying your current bills and need a reduction in monthly payments in order to be able to do so. If you need help learning to manage your money and want to enroll in a credit counseling program, you can always get credit counseling – whether or not you decide to do debt management. Either way, the first step is to start by contacting a credit counselor from among the ones recommended by the Department of Justice or by using the National Foundation for Credit Counseling website.
if you want to do a debt management plan with a credit counselor, ask them these important questions before you begin.
And if you enroll in the debt management plan, make sure you pay on time every month and keep tracking your statements from all of your creditors to ensure things are going according to plan – otherwise, your DMP and your finances could be jeopardized.
What Is Debt Settlement and How Does It Work?
Debt settlement is a more drastic option than either debt consolidation or debt management. With debt settlement, you are telling your creditors “Sorry, I can’t pay the entire amount I owe, but I can pay a fraction of it to you right now if you’ll cancel the debt.”
As you can imagine, doing debt settlement will hurt your credit score pretty significantly. It’s not something you should do before considering other options. However, for some people, it will be the best option.
While there are many debt settlement companies out there, it’s worth pointing out that you can attempt to negotiate settlements on your own. We’ll describe the pros and cons of this below.
But first, here are the steps you can expect to go through if you use a debt settlement company:
1. You contact the debt settlement company. They will ask you for the details of your situation, including the amount of debt you owe and the different types of debt you have, as well as the amount of income and savings you have that can be used to pay off debt.
2. They ask you to sign a contract. If you agree, you will have to begin paying them each month instead of paying your creditors. The money you pay will be held in an “escrow” account, which means it will not be given to your creditors immediately. Instead, the debt settlement company waits until you have accumulated enough money in your escrow account to make a lump sum offer to settle your debts. Sometimes this can take months.
3. The company attempts to negotiate with your creditors. Once you have enough money in the escrow account, the company will begin to contact each of your creditors (the banks and credit card companies that you owe money to) and attempt to negotiate a settlement where you pay some percentage of your outstanding balance as a lump sum in return for having the debt canceled.
4. If it works, your debt is reduced. Assuming you’re working with a legitimate debt settlement company, they might be able to negotiate lower balances on some or all of your debts. For example, if you owed $5,000 on your Bank of America credit card, it might be settled for $3,000. That’s the potential positive impact of debt settlement.
5. If it doesn’t work, you’ll be in worse shape. Why? Because you will potentially lose two things you can’t afford: time and money. If the settlement offers are not accepted by your creditors (or very few of them) you will be months or years behind on your payments. Legally, the company must give you back the money in the escrow account if they fail to settle any of your debts. However, if they settle some of your debts they will be able to take a fee (which can be a flat fee or a percentage) from that escrow account.
The Bottom Line:
You should always read the fine print before signing up for a debt settlement program. Be sure to ask about their fees and their timeline for settling your debts. And read these excellent recommendations from the FTC prior to enrolling in any debt settlement program.
One of the hardest parts of the debt settlement process is that you will be contacted constantly by your creditors during the months/years you are accumulating money in the escrow account. An insightful Wall Street Journal article in 2010 discussed some of the psychological impacts of debt settlement and how to cope with them.
Most importantly, keep in mind that some of your creditors may have rules against working with debt settlement companies – and in fact, a lot of evidence suggests you may have more success negotiating settlements on your own. So think about tackling settlement on your own, and if you do, utilize the practical tips in this article. And remember, you must be sure to get written confirmation of any settlement agreement before paying your creditors a lump sum.
What Is Bankruptcy and How Does It Work?
Most people are familiar with bankruptcy and view it as the most drastic of all possible ways to get out of debt. It’s true that bankruptcy is in some ways more drastic than the options mentioned above, but there is no reason to be scared or embarrassed about bankruptcy if that is truly the best option for you. It is much better to go through bankruptcy than to do nothing or to try a debt reduction method that is not appropriate for you and have it fail. However, there are some nuances that you need to understand before making a proper decision about bankruptcy.
There are actually two types of bankruptcies for individuals:
- Chapter 7 Bankruptcy: The most common form of bankruptcy, also known as the “liquidation bankruptcy.” Although many people mistakenly believe you have to lose all your assets in a Chapter 7 bankruptcy, the reality is that you get to keep any assets that are covered by the exemption law in your state. Every state has its own law regarding which assets are exempted, and the majority of people who file for Chapter 7 are able to keep all of their property. Any unprotected assets you may have (such as money in your checking account) will be liquidated by the bankruptcy trustee in order to pay back your creditors.
- Chapter 13 Bankruptcy: Also known as a “reorganization bankruptcy.” You file a “repayment proposal” that outlines how you will pay off some of your debts over a period of 3-5 years. According to the U.S. Courts website, “Chapter 13 acts like a consolidation loan under which the individual makes the plan payments to a Chapter 13 trustee who then distributes payments to creditors.” To be eligible for this type of bankruptcy, you must have less than $365,475 in unsecured debt (such as credit cards and medical bills) and less than $1,081,400 in secured debt (such as auto or home loans). The bankruptcy trustee will be in charge of your repayment plan, and your payments go to them. How much you need to pay each month will depend on factors like your income, expenses, kinds of debt, etc. In some cases, Chapter 13 can help people save their car or home by giving them 3-5 years to get caught up on their payments toward those debts.
The Bottom Line:
The most obvious impact of going through bankruptcy is that your credit will be hurt. But this may be a small prices to pay for being debt free, especially if you’ve evaluated all your options and can see that this is the best one for you. Even if you go through a bankruptcy, you will still be able to rebuild your credit and borrow money in the future. It’s important to research all the options, but don’t hesitate to talk to a bankruptcy lawyer if you’re thinking about filing for bankruptcy. That person can help you navigate this decision and explain how the process works. You can visit the National Association of Consumer Bankruptcy Attorneys’ (NACBA) website for a bankruptcy attorney near you. As always, it’s a good idea to know exactly what you’re getting into before you make any commitments or any decisions.
If you want a more detailed description of the bankruptcy process, you can read our previous article, Basics of Bankruptcy: How to Know When It Is Your Best Option.
What Is “Do It Yourself” Debt Reduction?
The phrase “do it yourself” is pretty self-explanatory. But can anyone really get out of debt on their own?
Yes! In fact, people do it quite frequently. The key is to inform yourself so you can take the specific actions necessary to improve your situation.
Here are steps you can take if you decide to get out of debt on your own:
1. Reduce your interest rates. Sometimes just getting some breathing room is the most urgent thing. If that’s the case, you can often call your credit card companies and ask them to lower your interest rates. See our blog post on how to lower your interest rate with a simple phone call.
2. Inquire about hardship programs. Most people don’t realize it, but credit card companies and other creditors (including health care companies) usually have something called a “hardship program” for people who are in danger of drowning in debt. Use these tips to find out about hardship programs. You should know that although inquiring about a hardship program will not hurt your credit score, if you mention that you can’t pay your bills then any available credit you have with that institution may be cut or eliminated.
3. Fix your budget. In order to get out of debt on your own, you’ll need to make your money go further. That means becoming a dedicated budget enthusiast! Try using this handy budget spreadsheet to track where your money goes each month, and then squeeze every last penny you’ve got into your debt repayment.
2. Use free online tools to manage your debt. There are a lot of great free tools online that can help you with this process. One of these is ReadyForZero, which helps you visualize your debts all in one place and gives you an automatic plan for how to pay them off. This can really help motivate you to get out of debt.
The Bottom Line:
Doing debt reduction on your own is not something that will work for everyone. For some people it will be the easiest way to get out of debt, and for others it will be impractical. That’s why it’s a good thing that other options exist. But if you’re not ready for debt settlement, debt management, debt consolidation, or bankruptcy, it could be a perfect option for you. If you’re interested in how this has worked for people in the past, check out these stories of people who have had success getting out of debt.
It can be hard to navigate through all these different ways to get out of debt and find the best one for your unique situation. So we hope this blog post has helped you understand which is the best way to get out of debt for you. Also remember that if you’re finding it hard to stop spending money even though you know it’s necessary, there are groups that can help you face the psychological challenges of controlling your spending behavior. One group that many people find helpful is Debtors Anonymous, which is free to attend and has meetings throughout the U.S.
And no matter which path you choose to take, we want to help. We’re always here to answer your questions. Just post a comment below with your question. Also, if you have had experience with any of these programs (good or bad) please leave a comment below and tell us about it.
This article is part of our Credit Card Debt Resource Center and Debt Consolidation Resource Center. If you’re looking for additional information about credit card debt or debt consolidation, be sure to pay a visit!
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