How Does Debt Relief Work?

The types of debt relief programs available

Debt settlement

With debt settlement, you stop paying your normal bills and instead make smaller monthly payments to a debt settlement company.

The company then uses that money to build up lump-sum payments it will offer to your creditors. Usually, the amounts are much less than what you owe.

Basically, the company is trying to convince your creditors that they’ll never get everything they’re owed, so they should just take what they can get.

How debt settlement works: Let's say you have $10,000 in credit card debt. Your debt settlement company will negotiate with your creditor, saying, "Hey, my client may not ever pay off the whole balance, but we have $7,500 in hand right now. Will you take that instead and forgive the rest?"

It's a risky way to settle your debt. Sometimes it works out; sometimes it doesn't.

It depends whether your creditors are willing to work with debt settlement companies — which is something you need to find out before you sign up with one.

What to watch out for: Unsurprisingly, creditors don't like it when you quit paying your bills. It's likely you'll be hit with late fees and/or accumulating interest. Your debt could go to collections, you could be sued for repayment and your credit score could tumble.

Debt settlement companies charge their own fees, so you might have to pay 15% to 25% of either your original debt or any forgiven debt. That means if you have $20,000 in debt and it's knocked down to $12,000, you could face fees ranging from $1,200 to $5,000.

If you’re using a debt settlement company to handle more than one debt, it’s important to note that they can start charging you fees as soon as the first debt is settled.

That means if they settle your largest debt first, you could be on the hook for a hefty portion of your total fee while you’re still trying to get your other unsettled debts under control.

Another thing to consider is that debt settlement has become prime territory for scam artists. Do your homework, be skeptical of companies that promise things that are too-good-to-be-true and never pay upfront fees. They're illegal.

Debt consolidation or debt relief loans

Debt consolidation is a way to restructure debt by rolling multiple balances into one neat little debt package.

You take out a new loan, ideally with a lower interest rate and better terms, and use it to pay off all of your current debts. You haven’t reduced your overall debt, but it’s more organized and you might save a lot in interest in the future.

How debt consolidation works: Let's say you have $25,000 in medical, student loan and credit card debt. You're already feeling swamped, and compound interest just keeps piling up and making it harder to keep your head above water.

So, you take out a $25,000 loan — maybe a fixed-rate personal loan or a home equity line of credit (HELOC) — and in one go you pay off multiple debts.

Now you have to pay just one loan with one interest rate. No more juggling debts with different due dates.

Another form of debt consolidation is through a balance transfer credit card, which allows you to transfer debts onto a single credit card with a low or 0% APR.

Before you apply, make sure your debt is transferable. You won't be permitted to move balances from one credit card to another if they both came from the same bank.

What to watch out for: Balance transfer cards often charge fees for transferring a balance, and their low "teaser rates" are temporary, lasting less than two years. If possible, you should try to pay off your entire debt during that time frame. Pay attention to what the interest rate will be after the promotional period ends.

And keep in mind that if you consolidate into a longer-term personal loan, you’ll usually suffer a higher interest rate, so keep the term as short as you can and don’t use debt consolidation as a way to push your problems off.

More: Best personal loans

Bankruptcy

Bankruptcy is the big kahuna of debt relief options because of its ability to totally eliminate debt.

Bankruptcy — either Chapter 7 or 13 for individuals — is a legal process in which you apply to have your debt either completely or partially forgiven.

How bankruptcy works: Chapter 7 bankruptcy is the most common form of personal bankruptcy and can wipe away most unsecured debts — that is, debts not backed by collateral. You might be forced to sell some of your assets, like jewelry, though this is relatively rare.

In Chapter 13 bankruptcy, your debts are restructured, and you're put on a three-to-five-year repayment plan. When that time is up, any remaining balances may be canceled.

Chapter 7 is intended for people who don't have the income to repay their debts. Chapter 13 is often called "wage earner's bankruptcy" and is meant for consumers with regular incomes. Either type can cost hundreds or even thousands of dollars in filing and attorney fees.

What to watch out for: Be prepared for your credit score to tank by at least 200 points when you declare bankruptcy. Bankruptcy also stays on your credit report for a really long time: 10 years for Chapter 7 and seven years for Chapter 13.

You can slowly start rebuilding your credit with secured credit cards shortly after declaring bankruptcy, but it could be difficult to get a car loan or mortgage for several years.

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Is debt relief the solution for you?

Debt relief measures aren't for everyone. Your credit can take a hit and, depending on the route you choose, you could wind up with even more debt.

If you have the means to pay off an unsecured debt within five years, it’s worth pursuing a do-it-yourself option, like creating a stricter budget or taking out a consolidation loan.

That way you can skip big fees, avoid being scammed and prevent your credit score from taking a huge hit.

Remember, compound interest is a huge stumbling block when you’re trying to tackle debt on your own, so it’s a good idea to pay off your high-interest accounts first with the help of a fixed-rate loan or a balance transfer credit card.

If you’re still struggling to clear your debt and think you might need to pursue debt settlement or bankruptcy, it’s not the end of the world. Just do your homework and make sure you understand all the potential risks.