As we approach Debt Awareness Week, the average American household now has more than $100,000 in debt. Total household debt has increased by $210 billion in just three months to reach a record high of $17.5 trillion.
If you’re feeling crushed by constant debt payments, you’ve likely looked into debt relief options. These can provide much-needed relief from overwhelming balances. But what’s the catch? Does debt relief negatively impact your credit? This article unpacks what debt relief is, how it can affect your credit, and guidance on when it may be the right choice for you.
What is Debt Relief?
Debt relief is a general term for strategies that can help reduce or eliminate the burden of debt when you cannot make regular payments. There are three key types of debt relief – debt consolidation, debt settlement, and bankruptcy. These options may help those struggling with unemployment, excessive medical bills, a divorce, or simply more debt than they can manage through regular payments.
1. Debt Consolidation
Debt consolidation is a strategy for managing multiple debts by taking out a new loan and using it to pay off multiple existing debts, condensing them into a single loan. Instead of juggling multiple creditors and due dates, debt consolidation creates one monthly payment to manage.
By consolidating your debts, you might qualify for a lower interest rate than some of your existing debts, particularly credit cards with high APRs. This can save you money on interest in the long run and help you pay off your debt faster. Additionally, a consolidation loan can provide a structured repayment plan with a fixed interest rate and term, making it easier to stay on track.
2. Debt Settlement
Debt settlement involves negotiating with your creditors to allow you to pay off a debt for less than the amount you originally owed. This option is only for unsecured debts, like credit cards or medical bills.
Debt settlement is typically done by a third-party debt settlement company that negotiates with your creditors on your behalf, trying to get them to agree to accept a smaller payment to settle the debt. If your creditor agrees to settle the debt, you will stop making payments to your creditors directly and instead deposit money into a savings account managed by the debt settlement company. The creditor will then collect this money to repay the debt.
3. Bankruptcy
The bankruptcy process helps people or businesses who are unable to pay their debts. For individuals, there are two main types of bankruptcy. Chapter 7 bankruptcy is the most common type for individuals and is often called “liquidation bankruptcy.” In Chapter 7, some of your assets may be sold to pay off your creditors, but you can be relieved of most of your remaining debts.Â
Chapter 13 bankruptcy allows you to create a court-approved repayment plan to repay your debts over three to five years. Under Chapter 13 bankruptcy, debtors get to keep their assets but must make monthly payments to a court-appointed trustee who distributes the funds to their creditors.
The Impact of Debt Relief on Your Credit
Any form of debt relief will have at least an initial negative impact on your credit score, as it requires negotiating with creditors or formally falling behind on payments, which leaves a negative mark on your credit report. The extent of the credit score impact depends on your overall credit history and the specific debt relief method utilized.
Debt settlement can cause an immediate, severe credit score drop because it involves intentionally becoming delinquent on payments to motivate creditors to accept a settlement. This can cause your score to fall by more than 100 points and may remain on your credit report for seven years.
Debt consolidation through a new loan or balance transfers can also negatively affect your score in the short term due to the credit inquiries from applying, potential credit utilization increases from balance shuffling, and loan modifications showing up on your report.
However, the long-term credit impact of responsible debt relief can be positive if it helps you escape from overwhelming debt you couldn’t handle through regular payments alone. Successfully resolving delinquent debts and getting them off your credit can lead to positively impacting your credit over time as you practice good credit habits. Debt relief can help you become debt-free faster than slowly paying it off. It also reduces your monthly payment burden and offers mental relief from debt stress.
Is Debt Relief Right for Me?
You should explore all other options before resorting to debt relief. However, if you have diligently tried numerous strategies to independently manage and pay down your debts but have failed to make any meaningful progress in reducing your balances, debt relief may be the necessary next step.
Debt relief may be needed if you constantly fall behind on minimum debt payments despite your best efforts to catch up or if your total debt load has become so unaffordable that you struggle to cover essential expenses like housing, utilities, and groceries.
However, debt relief is not always the best solution. If you can reasonably pay it off in under five years through your own efforts and budgeting, it’s likely better to avoid debt relief programs that will negatively affect your credit score. The same is true if you have a temporary short-term financial hardship; riding it out while making minimum payments may be wiser than negotiating relief.
Determining if debt relief is right for you requires carefully evaluating your entire financial picture, including your income, expenses, debt balances, interest rates, credit history, and more. This analysis can help you decide if the short-term credit score impact from debt relief is outweighed by the benefits of resolving your unmanageable debt for good.
Habits for Healthy Credit
Whether you decide to strengthen your credit score without debt relief or need to recover after debt relief, healthy credit habits are always essential for your financial freedom. Your payment history is the most influential factor in your credit scores, so making all future payments on time is crucial. If available, setting up automatic payments is a great way to ensure you don’t miss a payment. If you aren’t able to automate your payments, monthly reminders are key.
Your credit utilization ratio is also a key factor in a healthy credit score. This measures how much of your available credit you have in use. Lenders and credit bureaus generally want to see you using less than 30% of your total available credit limits across all cards and lines. Higher utilization can significantly negatively affect your scores.
While it can be tempting to close out older credit card accounts once they’ve been paid off, leaving them open is better for your credit scores. The length of your credit history is factored in, so closed accounts eventually drop off and lower your overall age of accounts. Freezing your cards to prevent adding new charges is a better alternative.
Limiting credit inquiries from new applications is also advisable to strengthen your credit. Each application can cause a small temporary dip, so avoid opening too many new accounts at once whenever possible.
The Bottom Line
The temporary credit score impact from debt relief may be worthwhile if you’re struggling with unmanageable debt that prevents you from covering essential living expenses or making any meaningful progress in paying down balances. However, debt relief isn’t the best solution for everyone. If your debt is manageable and can reasonably be paid off within five years through budgeting and discipline, it is best to avoid credit-impacting debt relief programs.
For personalized help with escaping debt, download the Credit & Debt app and get started for free. Credit & Debt offers free, live support with professional financial coaches to help you manage debt while strengthening your finances, helping you reach a new level of financial freedom.
