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Debt Management vs. Debt Settlement: Which Is Best?

Need help getting out of debt? Here's expert advice on two options

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Getting professional help to manage your debt isn't always easy.

See also: Find extra money to pay off debt.

For starters, federal authorities and consumer advocates often warn people in debt about scam debt relief agencies that promise assistance, but do nothing more than take your money. Even if you manage to avoid the con artists, how do you know the differences between debt management programs and debt settlement firms? And what should you expect if you choose to utilize either of these options?

Here is some guidance on the differences between debt management agencies and debt settlement companies, along with the pros and cons of using each.

Services Offered
Debt management firms and debt settlement companies both generally offer to help you eliminate unwanted or unmanageable debt, such as credit card bills and medical expenses. To reduce your debt, both types of agencies will negotiate with your creditors to do any of the following: 

debt challenge settlement vs management hand struggling

— Photo by: Colin Anderson/Getty Images

  • Lower your payments 
  • Reduce outstanding balances
  • Get late fees or penalty charges eliminated

One difference in services offered is that debt management firms often double as credit counseling agencies. That means debt management firms offer financial education services, such as teaching you about budgeting, cash management, and the proper use of credit and debt.

Next: How these companies operate. >>

How They Work
Debt management companies and debt settlement firms operate in completely different ways. That's because debt management agencies actually came into existence as a creation of banks and other creditors.

Back in the 1980s, banks needed to come up with a way to reduce their losses when consumers didn't repay debts or when people filed for bankruptcy protection. The banks' solution was to create a third-party system — debt management agencies — that would work with consumers to get them to repay some, if not all, of their debts.

Consequently, most debt management firms today focus primarily on reducing your interest rates and late charges to make your debt repayments more affordable. Many debt management agencies have deals with credit card companies to knock your rates down to a pre-set level. For example, your Citibank Visa card may have an 18 percent rate. But if you enroll in a debt management program, your interest rate can be lowered into the single digits or even to zero.

With debt settlement firms, no such deals exist. Debt settlement firms require you to stop paying your bills for a period of about six months. After that, the debt settlement firm approaches your creditors to begin settlement negotiations.

Debt settlement firms operate on the premise that, after your creditors have not been paid for many months, they'll be more likely to settle your debts — perhaps for pennies on the dollar — in order to get some money, as opposed to taking a total loss.

Credit Consequences
If you use a debt management firm, they often require you to close your credit cards and agree to a single, consolidated payment in order to pay off your debts.

Closing credit cards can potentially lower your credit score.

Enrolling in a debt management program will also cause a "DMP" notation to appear on your credit report. This stands for "Debt Management Program." Fair Isaac, the company that created FICO credit score, says a "DMP" notation and enrolling in a debt management program has no negative impact on your credit score.

Using a debt settlement company can have disastrous consequences for your credit score. A single 30-day late payment on a credit card can lower your credit score by 50 points or more, FICO officials say. So the damage to your credit can be enormous if you have multiple credit accounts go six months delinquent.

Next: Find out which one costs more. >>

Financial Costs
Costs vary to use different debt elimination programs. But $25 a month is a common monthly fee for many debt management services. Most debt settlement companies charge you in one of two ways:

  • a flat fee, which often runs $1,000 or more, and is based on how much money the debt settlement "saves" you by negotiating with your creditors
  • a percentage fee, typically ranging from 15 percent to 20 percent of your total debt

So if you have $10,000 in debt, fees would run about $900 for a typical three-year debt management plan, compared with fees of $1,500 to $2000 for a three-year debt settlement program

Many debt settlement firms also charge an additional monthly fee to their clients. These fees range from $20 a month to $100 a month. Fortunately, thanks to financial reform, since Oct. 27, 2010, debt settlement firms have been banned from charging upfront fees for their work, as they had done in the past.

Tax Implications
There are no tax implications of using a debt management program. If you enter into a debt settlement plan, however, you will have to pay taxes on the amount of money you saved.

For instance, if your debt was $10,000 and the debt settlement company convinced your creditors to settle your debt for only $3,000, you will be required to pay taxes on the $7,000 you saved. If you are in the 25 percent tax bracket, you'll have to fork over $1,750 to the IRS, because the government deems your $7,000 in savings as income.

The Winner: Debt Management
As you've probably surmised, I'm not a big fan of debt settlement firms because even with the "best" of them, you often pay high fees, suffer negative tax consequences, severely damage your credit rating, and get scant financial education to help you learn how to use credit and debt wisely.

Also, with debt settlement companies, your "success" in getting rid of your debt is tied to the company's ability to negotiate a settlement with your creditors — something that can't be assured since some creditors will simply refuse to cave in to a debt settlement company's demands.
By contrast, a reputable debt management company will provide free or low cost services, can help you preserve your credit rating, and will have financial literacy offerings as well to teach you to properly manage your overall budget.

A good debt management agency will also more successfully deal with your creditors because debt management firms have existing relationships and pre-arranged agreements with the creditor community to get you financial relief.

Lynnette Khalfani-Cox, The Money Coach®, is a personal finance expert, television and radio personality, and a regular contributor to AARP. You can follow her on Twitter and on Facebook.

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