Credit counseling vs. debt settlement: Which path should you choose?

Credit counseling, through a debt management plan, has you repay everything you owe at a lower negotiated rate over about three to five years, with your accounts kept current. Debt settlement has you stop paying so that the balances can later be settled for less, which means years of credit damage, possible lawsuits, sizable fees and a possible tax bill. If you can repay the principal within about five years at a reduced rate, counseling is the better route; settlement belongs in the same conversation as bankruptcy, for people who can’t.

How a debt management plan works

A nonprofit credit counseling agency reviews your budget, then proposes a plan to your card issuers. Issuers that accept usually lower the interest rate, waive some fees, or both. You make one monthly payment to the agency, which pays each creditor, and the plan runs until the balances are paid in full, typically within three to five years.

The costs are modest but real. Agencies charge a setup fee and a monthly fee, which some states cap, and a reputable agency will reduce or waive them if you can’t afford them. The cards in the plan are usually closed.

The credit effect is milder than most people expect. FICO says a notation that you are in a debt management plan is not counted against your FICO score, although a lender reviewing your file by hand can see it. Closing the cards can raise your credit utilization, which is the main short-term cost. It does not shorten your credit history: closed accounts in good standing stay on your report for up to 10 years and keep counting toward the age of your accounts. Meanwhile, every on-time plan payment adds to the payment history that makes up 35% of a FICO score.

How debt settlement works

A for-profit settlement company tells you to stop paying your creditors and to deposit money each month into a dedicated account instead. As months of missed payments pile up, the accounts go 30, 60, 90 and eventually 180 days late and are charged off. Once enough money has built up, the company offers a creditor a lump sum to settle one account for less than the balance.

Federal rules limit how the company gets paid. Under the FTC’s Telemarketing Sales Rule, which covers debt relief companies that sell by phone, including when you call them from an ad, a company may not collect any fee until it has settled or changed the terms of at least one debt, you have agreed to the deal, and you have made at least one payment to the creditor under it. The fee must be proportional to the debt settled, or a fixed percentage of what you saved. The money in the dedicated account is yours, held at an insured institution, and you can withdraw it. The FTC’s compliance guide lists the disclosures the company must make first.

The risks are the ones the CFPB lists in its guide to debt relief programs: late fees and penalty interest keep growing, creditors don’t have to negotiate, some sue before a settlement is reached, and the process “may well leave you deeper in debt than you were when you started.” A lawsuit can end in a judgment and wage garnishment, and the settlement company won’t defend you in court.

The numbers on $20,000 of card debt

These are illustrative assumptions, chosen to be realistic rather than flattering to either side.

• Keep paying the cards yourself at an APR of 24% with $445.53 a month: 116 months and $31,317 in interest.
• Debt management plan at a negotiated 8% over 60 months: $405.53 a month, $4,331.67 in interest, plus fees of, say, $50 to start and $40 a month, or $2,450. Total paid: about $26,782, with your accounts never late.
• Settlement, if everything goes to plan: suppose the balances grow to $23,000 while you stop paying, creditors accept 50%, and the company charges 20% of the $20,000 enrolled. You pay $11,500 to creditors plus $4,000 in fees, or $15,500. The $11,500 forgiven is taxable unless you are insolvent: at a 12% federal bracket that adds $1,380, for about $16,880.

On paper, settlement can cost less in dollars. What the arithmetic leaves out is the price you pay in other ways: several charge-offs that can stay on your reports for about seven and a half years, the chance that one creditor sues instead of settling, and the chance that you can’t keep up the deposits and end up with neither the debt reduced nor your credit intact.

Taxes on settled debt

Forgiven debt is generally taxable income, whatever the amount. A creditor that cancels $600 or more must file Form 1099-C, and you report the canceled amount on your return. The main exception for people in this situation is insolvency: if your debts exceeded the fair market value of your assets right before the cancellation, you can exclude canceled debt up to the amount you were insolvent by filing IRS Form 982. The IRS explains the rules in Topic No. 431. A debt management plan creates no tax because nothing is forgiven.

How to check an agency before you sign

1. Confirm that a counseling agency is a nonprofit and is accredited, for example by the National Foundation for Credit Counseling or the Financial Counseling Association of America.
2. Check your state attorney general or banking regulator for any license your state requires and for complaints.
3. Ask for every fee in writing, and what happens if you miss a plan payment.
4. Walk away from anyone who charges a settlement fee before settling a debt, guarantees a result, or tells you to stop talking to your creditors.

The FTC’s credit and debt guidance covers more warning signs.

Which path fits

Start with one question: could you repay the principal in about five years if the interest rate were cut? Divide your total card balances by 60 and compare that with what your budget allows. If the answer is yes, a debt management plan is the cheaper option once credit damage and risk are counted. If it is clearly no, talk to both a nonprofit counselor and a bankruptcy attorney before you consider settlement. Bankruptcy stops lawsuits and garnishment the day you file, and a Chapter 7 discharge is not taxable income, two protections settlement doesn’t offer.

If your rate is the main problem and your credit is still good, a debt consolidation loan or a hardship program from your issuer may solve it without either route.