Dear Debt Adviser,
I am confused on how some debt management companies claim that they can take at least 40 percent to 60 percent of the credit card debt that you owe, and some companies will only lower interest rates. Your credit cards are inactivated with either approach. However, lowering interest rates through a debt management plan doesn't seem to affect credit as much as when you pay less than the total amount owed in debt settlement. What are the pros and cons of these programs? I do realize people's circumstances are different, but in general, please explain.
You're confused? Me too!
Not only are there so many competing claims out there, but many of them seem to be, and are, baldfaced lies. There are legitimate pros and cons to each of these approaches when they are done right. But first I need to take out my machete and hack a path for you through this jungle of company claims. In other words, the company you choose is at least as important as the type of solution it offers.
So let's start with how to choose the right company for you.
Typically, companies that try to get lower interest rates are nonprofit credit counseling agencies. As a group, they have been vetted by the IRS and the Federal Trade Commission and have established accreditation and certification as the gold standard for industry players. Insist on third-party accreditation and counselor certification along with nonprofit status, and you shouldn't go too far wrong.
A counselor should spend at least 45 minutes to an hour with you discussing your specific situation, and you should receive a written action plan. All counseling should be free, and any monthly fees for a debt management plan should be disclosed upfront and not exceed $40 per month.
Debt settlement companies that try to reduce the amount you owe are much less regulated and do not have clear, widely accepted standards in place. As a result, I advise you to deal with a reputable law firm that does only this sort of work. Attorneys have extensive standards and ethics rules in place, along with a professional code of conduct. Use a local firm if at all possible, so any issues that may arise can be handled in person. This is an adversarial process. Lenders don't want to settle for less than is owed unless they initiate the offer.
Now for some of the differences in how credit counseling and debt settlement work and how each will affect your credit.
To get lower interest rates and fees, many consumers who receive credit counseling decide to enter into a debt management plan. Under such a plan, the consumer makes a specified monthly payment to the credit counseling agency, and the agency disburses payments to the consumer's creditors. The plans vary in length, typically from 36 months to 60 months. Any accounts included in a debt plan must be closed. Fees for the plan should be low -- and reduced or waived if you can't afford them. An enrollment fee should not exceed $75 but most are less.
Once an account is placed on a debt management plan, any collection calls stop in a month or two once payments begin. Being in a debt management plan does not affect your FICO score. However, how your lenders report your accounts to the credit bureau can affect your score.
A debt settlement company typically charges a substantial enrollment fee and requires that you pay a monthly amount to the company. The money is then placed into an account for payment to your creditors. The money has to accumulate to an amount equal to 20 percent to 50 percent of the debt before it's paid out. I would hesitate to give this much money to a stranger to hold, but an attorney's escrow account usually has built-in safeguards.
What many people don't realize is that until the escrow account is funded, you will continue to be subject to collection actions, and your credit will continue to deteriorate. If a lender refuses to settle, you could end up in court with your wages garnished. So if you decide to settle your debt, your credit will reflect increasing delinquency, charge offs and court actions that may occur.
One last reason to use an attorney is that if you end up in court, a nonlawyer settlement company will drop the account because they are not allowed to give legal advice.
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