Debt Management vs. Debt Settlement: Which Is Best?

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. >>