If you are deep in debt, you might thought of other available options for getting out of debt, other than paying the monthly minimum amount or a little over it. At the same time, the thought that these other available debt relief options can affect your precious credit might have crossed your mind.
So what’s the real score for your credit score? Can debt relief options really affect your credit?
Types of Debt Relief
There are four debt relief options available for debtors today. These are credit counseling, debt consolidation, debt settlement, and bankruptcy. Each has a different approach and has different pros and cons, as well.
In credit counseling, a debtor sits down with a credit counselor, who examines his or her financial struggles, then recommends the best approach for dealing with debt. The credit counselor comes up with a debt management plan (DMP), which the debtor ought to follow in order to get out of debt within the planned time period, the immediate financial goal that needs to be addressed. Depending on the debtor’s situation, the credit counselor may recommend other debt relief options such as debt consolidation, debt settlement, or bankruptcy.
Note that credit counseling is different than Debt Management Plan. Credit counseling refers to the counseling session, while DMP refers to the action plan that is a result of the said counseling session. In effect, credit counseling per se does not have a direct effect on credit, but the resulting Debt Management Plan may have.
In debt consolidation, all debts of a debtor are combined (consolidated) into one single loan that is big enough to cover the total debt amount. The said loan will come from a debt consolidation company and will be used to pay off all the existing debt accounts. Because the individual accounts are already paid off, the debtor’s new creditor will now be the debt consolidation company. The benefit of debt consolidation is easier management of accounts, compared to having several separate accounts to pay off.
Debt consolidation, per se, does not have an adverse effect on credit score because you are simply taking out another loan to pay off several accounts. In other words, you are simply transferring your debt to another creditor. However, if you fail to pay your new creditor, your credit score will surely take a hit.
In debt settlement, a debtor seeks help from a debt settlement company, who negotiates with his creditors on his behalf. The debt negotiation process requires that debtors stop paying the monthly dues to justify a financial hardship; otherwise, creditors would think that that the debtor still has the financial capacity to make the monthly payments, and continue charging fees and interest. Debt settlement’s approach is to suspend the monthly payments, then offer the creditors a partial payment which should be considered as a full payment to the total debt, because that is all that the debtor can afford. Typically, it’s around 30-65% of the total debt.
Debt settlement is an aggressive debt relief option, and works for individuals who have real financial hardship, which can be justified in their income and debt levels. Because debt negotiation requires the suspension of monthly dues, it will negatively affect one’s credit score since payment history is a major factor in credit rating. However, this effect does not stay forever in the debtor’s credit report. Over time, when he or she starts to properly manage his or her debts, then good credit score will eventually be restored.
Of all the debt relief options available, bankruptcy has the worst effects. A chapter 13 bankruptcy, for example, remains on your credit report for 7 years, while a chapter 7 bankruptcy remains for up to 10 years.
While bankruptcy may appear as an easy way to get out of debt, it has long-lasting implications to your financial life. For example, creditors typically don’t lend or extend credit to individuals whose credit reports indicate a bankruptcy filing. For as long as it appears, you may have to live on cash, including emergencies which might be quite a difficult situation for some people.
Take extra caution when thinking of bankruptcy. It should be considered the last resort, when all the other options have been exhausted.
As a final thought, we put this out to our readers: what is more important to you? Your credit score? Or getting out of debt? If you can get out of debt without ruining your credit report, then that would be great. However, for people with only a few options left, compromising credit score for freedom from debt might just be a necessary sacrifice.