Why Is Debt Management Important?
If you're burdened with debt that you can't seem to pay off, you may have been considering joining a debt management program. Debt management plans allow you to tackle your credit card debt and other debts while enjoying lower interest rates. To learn whether a debt management plan is for you, read on.
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- What Is Debt Management?
- Why Is Debt Management Important?
- How Will Debt Management Affect Your Credit Report?
- What Does a Debt Management Company Do? Tactics & Strategies
- Is Professional Debt Management a Good Option?
- Alternatives to Professional Debt Management
- How to Create a DIY Debt Management Plan – The Complete Guide
- Final Thoughts
What Is Debt Management?
When people refer to debt management, they're usually referring to one of two things: Debt management with a credit counselling agency or DIY debt management. Both options have their pros and cons.
Debt Management With a Credit Counselor
Debt management programs use a variety of tactics to negotiate a lower monthly payment, a lower interest rate, or a debt settlement. They can help you wipe out outstanding debt or pay off your debt and credit card accounts as soon as possible.
A credit counselling organization can also offer a debt consolidation loan and help you figure out payment plans and debt relief options.
However, not all debt management programs are good. There are a lot of scams and unscrupulous credit counsellors in the debt management industry, so it's important to be careful. It's best to go with a nonprofit credit counselling agency instead of for-profit companies.
Debt Management – The DIY Option
An alternative to credit counselling with a financial institution is managing debt by yourself. You won't always have access to the same resources as a reputable credit counselling organization, but you may still be able to negotiate lower interest rates with credit card companies by calling them and explaining your situation.
DIY debt relief is a good option if you want to save money on credit counselling session fees and don't have too much debt. In other words, it’s great if you can still afford to create a plan to tackle your debt by yourself. If you don’t have a stable income, it might not be a good option.
We'll talk more about DIY debt management and other debt-relief options later in this article. For now, let's focus on for-profit and nonprofit credit counselling agencies, what they do, and why they’re important.
Why Is Debt Management Important?
Debt management is critical for achieving financial stability and freedom. When you have debt weighing you down, you can’t save money. You’ll constantly be scrambling to use any extra money left over after your bills for paying off your debt collectors.
Depending on the type of debt you have, interest rates can be as high as 20-30%. Consider that investing in the stock market over the long term brings an average yearly yield of just 7%. You’ll quickly realize that as long as you’re in debt, any stock market gains will be wiped out by your debt interest payments.
Without debt management, those high-interest rates can add up, and paying your minimum monthly payment may only cover your interest without affecting your base debt. Professional debt management can help you lower those interest rates.
Even DIY debt management can help you figure out how to tackle your most pressing debt first (hint: it’s not the debts you’re being pressured about the most).
Also read: Can You Build a House for 50k?
How Will Debt Management Affect Your Credit Report?
In the long run, you can expect debt management to help you improve your credit scores with the credit bureaus, as you'll pay off your debt quicker. In the short run, however, it can hurt your credit report due to:
Hard inquiries into your credit score
Closing existing accounts and reducing your overall credit line
Opening balance transfer cards
Withholding payments as a negotiating tactic
What Does a Debt Management Company Do? Tactics & Strategies
Credit counsellors typically use one or more of the following tactics to help those in a bad financial situation. Some of these strategies are better in the long run than others, so it's important to get transparency from your credit counsellor.
Using debt consolidation to pay off your debt faster is the main tactic to look for.
A debt management company can typically negotiate better interest rates with your credit card issuers and other creditors. You'll have to close credit card accounts that you have open until you pay off the remaining balance you owe, though you might be able to keep one credit card for emergencies.
You'll get on a new payment plan and pay a single lump-sum payment each month to the debt management company. It will then distribute the money among your creditors, after having negotiated lower interest rates. The savings in interest can be significant and make a huge difference in helping you get out of debt and paying off your credit card bills.
Be wary of other tactics that some credit counselling agencies use. For example, some will stop paying your credit accounts as a strategy to get your banks to agree to lower interest rates. However, that can hurt your credit report.
Sometimes, credit counselling agencies will advise you to declare bankruptcy. However, that should only be considered as a final option, when there is absolutely no way you will ever be able to pay off your debt, and negotiating lower interest rates or debt consolidation won't work.
Also read: How Much Does One Person Spend on Groceries a Month?
What Is an Example of Debt Management?
Here’s a simple example of a debt management settlement. Let’s say you owe $60,000 across three different credit cards ($20,000 on each card), with an average interest rate of 20%.
A debt settlement company can talk with your banks and negotiate your interest rate down to 5%. However, instead of paying your credit card companies directly, you’ll pay the debt settlement company a fixed monthly payment of $5,000 for the next 12 months. That is just an example, as actual monthly payments and the length of the plan can vary.
The debt settlement company will then use that money to pay off your three credit cards. The company may require you to make monthly payments for six months before it starts negotiating your debt – that is to ensure that you have the money to make your monthly payments..
You’ll be charged an additional fee for the counselling session, and you may also be charged a fee for setting up your account. Additionally, the debt management counselling agency will either charge a monthly fee or take a certain percentage of the money you save (20-25% is typical).
Is Professional Debt Management a Good Option?
Debt management can be a good option if you are trying to eliminate debt and achieve financial stability, but you are having a tough time confronting all your debts. Credit repair agencies can help you fulfil your financial obligations while paying lower monthly payments.
Nevertheless, there are some pros and cons you should know about.
Debt Management Pros
A debt management company can help you reduce your credit utilization by making timely payments.
Debt management companies can often negotiate better interest rates than you would be able to by yourself, especially if you go with a trusted and well-known nationwide company. Lower interest rates on your repayment plan can translate to more savings for you.
You can get debt collectors off your back and reduce the stress in your life.
Making one monthly payment instead of several can make paying off your debt simpler and help you avoid missed payments.
A debt management counsellor can help you figure out which bad habits are causing you to fall further into debt.
Also read: Can I Pay Off My Mortgage Early?
Debt Management Cons
Some debt settlement companies charge rates as high as 25% of your savings, which may make it not worth it. Go with a non-profit agency like the NFCC that charges low monthly and startup fees.
You may have to put money into a savings account for several months before the debt management company starts negotiating your rates.
In the short run, debt management can hurt your chances of getting a higher credit score, as your counsellor might close accounts and the credit unions might see that payments are being made by a debt management company.
There are a lot of bad actors in the industry. Some will take your money and not even pay your debts on time, so it's critical to be careful.
You may have to pay a fee for credit counselling. With a little financial education, you may be able to pay off your debts and even negotiate lower interest rates yourself.
Alternatives to Professional Debt Management
Instead of using a debt settlement company, there are some effective alternatives other than simply spending all your money to pay off your credit card balance. These methods may require some more time and effort, but they are worth it.
Get a Debt Consolidation or Personal Loan
A debt consolidation loan is not the same thing as a debt settlement. Many debt management companies that advertise “debt consolidation” are doing debt settlement, which we discussed above: negotiating with your creditors for lower rates, collecting a single monthly payment from you, and then using that money to pay off your debts.
Taking out a debt consolidation loan gives you more control. Here’s how it works:
You approach a debt consolidation company or your local credit union and request a personal loan.
You find a loan with a lower interest rate than your average APR.
Then, you take out the loan and use it to pay off all your debts in one swoop.
You’re left with only one debt to pay off – the personal loan.
You don’t have to use a debt consolidation loan to pay off all your debt. You can take out a small personal loan only to pay off your high-interest credit cards, for example, while continuing to use your weekly paycheck to pay off your auto loan.
It’s critical to find a personal loan that has a lower interest rate. Many debt consolidation loans have interest rates that make them not worth it.
This method does not require you to negotiate better interest rates with your lenders, but it would help.
Negotiate Better Interest Rates
While debt relief companies may have connections that help them negotiate better rates, it’s often possible to do it yourself, especially if you are in a difficult financial situation. Many banks and credit card issuers have “financial hardship” programs for people who got hit with unexpected medical bills, lost their jobs, etc.
Even if none of that happened to you, call your bank and ask if they can lower your interest rates in exchange for you doing all you can to pay off your debts. Some will agree, some won’t, but it’s still worth trying.
Also read: How to Apply For a FHA Loan?
Use a Debt Transfer Card
Debt transfer cards allow you to transfer debt from other credit cards to a new card. The benefit of doing that is that debt transfer cards typically have a grace period with no interest or a lower overall interest rate.
However, if you don’t have a good credit score, you may not qualify for a debt transfer card in the first place. Furthermore, debt transfer cards often charge a fee for transferring your debt.
Use Credit Card Bonuses and Rewards
This method is a bit risky, as it requires a lot of discipline and can also hurt your credit score. However, using credit card cashback rewards to help you pay off your debt, is not recommended except for those with extreme discipline and a healthy cash flow.
On the other hand, some credit cards also give you bonuses of up to a few hundred dollars or more when you spend a certain amount within 1-6 months of opening your account. You can use those bonuses to pay off your debt.
It sounds good on paper, but the reality is that it can cause you to overspend to try to get that reward, and opening new accounts can also negatively impact your credit score.
Take Out a Home Equity Loan
This method is pretty risky, and we don’t typically recommend it. It involves borrowing against the equity of your home. While it’s an easy way to get some quick cash to pay off the rest of your debt, it can lead to you losing your house entirely, so consider it a last resort.
How to Create a DIY Debt Management Plan – The Complete Guide
What if you feel like you can tackle your debt by yourself? If you have a steady income, paying off your debt is just a matter of time and priorities. You’ll need to live on a strict budget for a while, but in the end, it will all be worth it.
Here is how to create a debt management plan by yourself.
Create an Emergency Fund
The first step is to save at least $1,000 for an emergency fund. Financial advisors typically say to have an emergency fund that will last you 3-6 months in case you lose your job. However, as paying off your debt should be a top priority, a thousand dollars or so to cover unexpected expenses could do the trick for now.
When you start paying off your credit cards, you’ll be able to use your ever-increasing credit line for emergencies – but only real emergencies, like urgent medical issues. Don’t fall into the trap of relying on your credit cards, or else you’ll never advance in your quest for financial freedom.
Figure Out Which Loans Have the Highest Interest Rates
Take a look at your different cards and loans and create a spreadsheet, ranking them by APR. You’ll want to pay off the debts with the highest interest rates first, as that’s the quickest way to crawl out of the debt lifestyle.
This strategy is known as the avalanche strategy. Of course, you’ll still need to make your minimum payments on your other credit cards or loans to avoid harming your credit score.
The avalanche strategy differs from the snowball strategy, which involves paying off your smallest balances first. For example, if you have one credit card that you owe $10,000 on with a 10% interest rate and another card with a balance of $200 and a 5% interest rate, you’d pay off the card with the $200 balance first.
The strategy you use is up to you. We recommend the avalanche strategy, as it will help you save money and get out of debt faster. However, the snowball strategy can be useful if you find it hard to find the motivation to pay off your debt, as it brings quicker results (loans you can scratch off your list and forget about forever).
Separate Secured and Unsecured Debt
There are two main types of loans. Some loans are secured, while others are not.
An example of secured debt is your auto loan. It’s secured by your car, which your creditors can repossess. Any loan for which you have property or assets as collateral is a secured debt.
Unsecured debt is debt that has no collateral. Most credit card debt, for example, is unsecured debt. The bank can’t automatically take your car if you don’t pay it on time.
Which type of debt should you pay off first? That depends on how important the collateral is to you. If your home is on the line, for example, or if your car is, and you need your car to earn money, pay off your secured debt first. Your assets are at risk if you don’t.
While secured debt typically comes with lower interest rates, you’ll want to make an exception to the avalanche strategy we mentioned above and pay them off first if the collateral is important to you.
However, if you rarely use your car, or if you can afford to take public transportation to work, it might be wiser to pay off your unsecured loans first, especially if they have higher interest rates.
Not all credit card debt is unsecured debt, by the way. For example, if you have a secured card for which you deposited money as collateral, you can push off paying the balance on that card until later.
Don’t Give in to Debt Collectors
Once you’ve decided which debts you must pay off first, don’t give in to the pressure of debt collectors who are hounding you. Debt collectors don’t have your best interests in mind; they want to get you to pay back a specific loan even when it shouldn’t be your top priority based on your debt repayment strategy.
Learn How to Manage Your Spending
It’s going to hurt for a while, but it’s critical to learn how to set a budget and manage your spending. Until you pay off your debt, you shouldn’t be spending your money on luxuries that you don’t need. Your debt should have top priority.
That doesn’t mean you can’t take a small vacation. If you need a vacation to avoid burnout and for your mental health, that’s okay. Just set a budget for it and don’t surpass that limit.
It’s all about priorities. Cut as many corners as you can and tackle your debt. You’ll feel much better once it’s all paid off.
Go All In
Finally, go all in and put all your extra money into your debt. If you get a bonus at work, use it to pay off your cards instead of buying yourself a new gaming computer.
While you want to avoid using your credit cards and racking up more debt, responsible credit card usage can help you pay off your debts quicker – if the card offers significant cashback rewards on purchases.
It must be cashback, not rewards points, so you can apply the rewards to future balance payments. Just make sure to pay off your balance each week or month. If you lack self-control, don’t do this, as the potential gain is not worth the risk.
Debt management, whether you go with a debt settlement company or do it yourself using methods like debt consolidation loans, is the surest way to crawl out of the ditch you dug for yourself by taking out loans you couldn't afford. It requires a lot of discipline, but a financial advisor can help you figure out a solid plan, motivate you, and keep you on task.
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