Debt reduction services can settle your debt but it also comes at a cost. Understand the pros and cons of debt settlement as well as other options available.
Let me start off by saying debt reduction services are not my favorite financial solution…by a long shot.
In fact, I’d say debt relief should be your last option if you absolutely don’t think you can avoid bankruptcy. Other financial experts have even made the case that bankruptcy might be a better option in certain scenarios.
But debt reduction is a financial tool and you need to know how to use it in case you run into trouble with debt.
What is a Debt Relief Program?
Debt reduction companies are really debt negotiators. They contact your creditors and argue to lower the amount of debt you owe. Once the debt reduction company has gotten all the debts lowered, they put you on a payment plan where you pay them directly.
Sounds pretty great but there’s a catch.
- Debt reduction companies charge a fee, usually around 20% of what you owe in debt. So if you owe $10,000 – the debt relief services will cost you $2,000
- Debt reduction services can take years to finalize. That’s how long it takes to negotiate with creditors and we’ll see in the next section how that can be a big problem for borrowers.
The alternative to a debt relief program is to consolidate your debt with a peer loan. I’ll highlight why it’s the better option later in the article including immediately improving your credit and saving on interest without destroying your credit score in the process.
How Does Debt Reduction Services Work?
When you talk to a debt relief counselor, they’ll first take a snapshot of your finances. You’ll lay everything out on the table including how much you make, how much you spend each month and all your debt.
If the debt settlement company takes your case, the first thing they will tell you to do is to stop making payments on your debt. This puts your debt into default and helps the relief service negotiate with your creditors. After all, the people you owe money to might be willing to take less than you owe rather than nothing at all.
The problem here is that while you aren’t making payments, you will be racking up thousands in late fees and interest. You’ll also destroy your credit score even worse than it already is and won’t be able to get any more loans.
The debt reduction company will also tell you to start putting money in a bank account they control. This goes to paying fees and eventually to paying the debt after they’ve settled with creditors.
For the next two or three years, you will be making payments into this account and the debt settlement company will be negotiating with creditors.
Does Debt Relief Work?
The Federal Trade Commission (FTC), the nation’s consumer protection agency, warns that most debt relief companies are only able to negotiate your debt lower by 35% or less. That might not sound too bad, paying $0.65 on every dollar you owe, but it isn’t really much of a savings when you tack on the 20% debt settlement fee.
Debt relief only works for about two or three people in every ten that try it. A lot of people have trouble making payments into the settlement company’s bank account and fall out of the program.
If you are able to keep up with the settlement payments, usually for at least two or three years, you’ll get your debt paid off. Debt settlement companies aren’t always able to negotiate with every creditor but they can usually get your total debt reduced.
Are there any Problems with Debt Reduction Services?
Debt reduction sounds great. You’re fighting all those calls from debt collectors, you can’t seem to get your head above water and you don’t see any way out of debt.
Then you see a commercial that promises to get your debt reduced to $0.50 on the dollar. The debt reduction company puts itself out there as credit professionals willing to fight for you.
There are a lot of problems with debt reduction services and most people end up worse than they already are with debt.
- All that time not paying your creditors destroys your credit score and makes it impossible to get any money, even emergency cash when you need it.
- Debt settlement usually takes about three years and it will take at least another five years afterward to build your credit score to the point where you can get good rates on loans.
- If you can’t keep up with the payments into the settlement company account, you’ll lose a lot of money and will still have to pay your creditors plus all the late fees and interest you’ve accrued.
- Even if you make it through the debt reduction program, most people only save about $0.10 on the dollar when accounting for settlement fees. Saving $100 for every thousand you owe isn’t much when you consider all the problems debt reduction programs can cause.
In fact, FICO estimates that it can take up to seven years to recover your credit score after being 90-days late on your mortgage. Going more than a year not making a payment on your debt can be just as bad.
How to Use Debt Consolidation instead of Debt Reduction
I hope you’re still there. Maybe I should have put this section higher in the article before rambling on about all the problems debt reduction can cause and scaring people off.
Instead of digging yourself deeper in debt and risking debt settlement nightmares, a debt consolidation loan might be your best solution.
I’ve highlighted debt consolidation and personal loans a few times on the blog as well as some of the bad credit peer lending sites I’ve used to dig myself out of a financial mess.
Debt consolidation is taking out one large loan, up to $40,000 on most loan sites, to pay off your other debt. Not only do you make it easier to manage your debt, by having to make just one payment a month, but you also save thousands on interest.
With debt consolidation, you start attacking your debt immediately. You might be behind on a few bills and have already hurt your credit score but at least you don’t have to wait years for a settlement company to finish negotiating.
There are no fees on most debt consolidation loans unless you miss a payment. You can pay the loan back in terms from six months all the way up to six years. That means you can stretch your loan out so payments are affordable.
Interest rates on peer loans range from around 6% to 36% for bad credit borrowers. That’s still much lower than most credit card rates and way under payday loan rates.
Personal loans for debt consolidation are also not secured with collateral, you don’t have to put up your house or car against the loan. It will hurt your credit score if you don’t make payments but at least you won’t have to worry about getting kicked out of your home.
There’s really nothing to lose by trying a debt consolidation loan before contacting debt reduction services. You’ll get the chance to lower your payments and interest rate to get back on your feet. If you still find you can’t make payments on your debt then there is always the debt settlement route later.
Checking your rate on a debt consolidation loan doesn’t hurt your credit because lenders do a soft-pull of your credit to approve your loan.
Debt Reduction Services Pros and Cons
I would highly recommend you look to debt consolidation before going to a debt reduction company. Through a personal loan, you can pay off all your other debt and potentially save thousands in interest. You’ll have just one payment a money for the consolidation loan and it will help build your credit score from day one.
There are a few pros for debt reduction services:
- Debt settlement usually comes with financial counseling to help you see where you are going off course with spending and budgeting
- Debt reduction companies are experts at negotiating debt. You can negotiate with creditors yourself but it can be very difficult unless you know all the rules and tricks.
- Debt negotiation can eventually reduce how much you owe, even after paying the settlement fee, and can help put you back on track.
The disadvantages of debt reduction outweigh the advantages for most people:
- You’ll have absolutely no access to credit while the settlement company is negotiating with creditors. You’ll be in default and no loan companies are going to give you a penny.
- You will destroy your credit score for years and it could take up to a decade to get your FICO score back up to where you started.
- Creditors may step up their push to get you to pay because they know you’ve hired a settlement company. This might mean more nasty mail and more phone calls.
Understand that debt reduction services are just a financial tool. Knowing how to use that tool will put you in the best position to use it if needed. I would recommend trying a debt consolidation loan first but it’s always better to have a tool in your financial toolbox and not use it rather than to not have it available.