Many working families have fallen into financial hardship under the changing economy. As a result, some have turned to credit counseling services to get out from under mountains of debt. Credit counseling can be a critical step toward recovery, but it can also impact your credit and cash flow for years to come. So, it pays to do your research before making such an important decision.
More Americans than ever live paycheck to paycheck, unable to save for the future or pay down their debt. A 2016 poll showed that two-thirds of Americans would have trouble covering a $1,000 emergency. Even more shocking is that 38 percent of households with annual incomes of over $100,000 would struggle to come up with that amount of cash. Between school loans, home loans, and credit cards, Americans find their liquid cash flow is drying up.
If you struggle to pay the minimums on your credit cards or are trying to improve your credit rating, a credit counseling service can get you back in control of your finances and your future. There are both pros and cons to working with a credit counseling service. Understanding them, and what to expect from the process, will help you make the best decisions. Not to mention certain red flags to look out for so you can avoid scammers who don’t deliver on what they promise.
What Does a Credit Counselor Do?
There are plenty of legitimate credit counseling services available, and their goal is to help you reduce your debt and take back the reins of your financial future. These trustworthy companies offer a free evaluation so you can find out if what they offer is right for your situation. Some even offer a free follow-up session to make sure your debt reduction plan is working as planned.
Along with helping you get back on track and up-to-date on your payments, they’ll help you stay on track, as well. Most offer financial management classes to keep you from falling back into that financial hole.
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The credit counseling process
Your credit counselor will evaluate the extent of your debt and expenses and help you create a budget that works within your income. They’ll also offer an analysis of your debt to income ratio, helping you identify weak spots in your finances. Another excellent service they provide is helping you improve your credit score. Your counselor will go over your credit report with you and advise you on how to improve your rating.
If your debt exceeds your income, making it impossible for you to save money or invest in your retirement, they can help you rebalance your budget. Many counseling services have pre-existing relationships with finance companies and can help you negotiate a repayment plan. This advantage can put a stop to all those harrowing phone calls.
Depending on your income and expenses, your credit counselor may be able to negotiate a lower monthly payment by extending the life of your loan. This service can be a significant relief if the sum of your minimum debt payments doesn’t leave you with any room for living expenses.
Many creditors, particularly credit card companies, automatically raise your interest rate when you are late with a payment. Your credit counseling company may be able to lower the inflated interest rate during the repayment period. This benefit decreases your payment and reduces the amount you’ll repay overall.
Once your counselor has reached an agreement with your creditors and has ensured you can meet those payments and still cover food, utilities, and other daily needs, they may offer you a debt management plan.
What is a Debt Management Plan?
In a debt management plan (DMP), the credit counseling service handles the repayment of your loans. One way these companies can reduce payments is by leveraging their existing relationship with creditors to ensure them that the new payment plan is paid as agreed. For many, this is the best method for avoiding bankruptcy.
When you enter a DMP, you agree to deposit money with the service every month and allow them to manage those payments to your creditors. For some people, the process can feel very invasive. The counseling service may require you to close your credit accounts. And oddly enough, closing your credit accounts may actually negatively impact your credit score. Your credit report now shows that you have less available credit than before, even though that credit has been tapped out.
And when you do reach your debt-free goals, you won’t be able to rely on the age of those accounts to raise your credit score. Reporting agencies base part of your credit rating on how long you’ve had your accounts. If you’re forced to close those accounts, you’ll have to start that aging clock all over again.
Another downside to DMPs is that they’re only suitable for certain types of debt, mainly unsecured loans. This includes credit cards, medical bills, and personal loans. Unfortunately, a DMP can’t help you catch up on your home loan or car payments. You’ll need to speak directly to your lenders to work out repayment plans for secured debt. However, your credit counselor can help you decide if a DMP is your best bet.
Debt Management vs. Debt Settlement
One red flag to keep in mind when looking for a credit counseling service is what kind of plan they offer. Do they offer a DMP or a debt settlement plan? There are distinct but essential differences, and you need to be aware of them. Some “credit counseling” firms offer other services that may not work in your best interests. One of these services is debt settlement.
Also known as a debt consolidation loan, a debt settlement plan can damage your credit even further. In a debt settlement, the provider is usually a for-profit organization. Debt consolidation services pay off your creditors in one lump sum and then charge you at a fixed interest rate to pay them back. On the plus side, it means you won’t be bothered further by any of your creditors. You’ll only have one debt payment to make every month, which simplifies your budgeting. And usually, the interest rate is lower than what you were paying to your creditors.
The downsides to debt settlement
Unfortunately, there’s a dark side to consolidation loans, too. These companies often recommend you stop making your loan payments until they can secure a better deal from your creditors. If this process drags out, each missed payment will go on your credit report. The resulting late fees also accumulate. Many times, the lender can negotiate with your creditors for a lower payoff amount. However, this goes on your credit record as “not paid as agreed,” which can also damage your credit score.
There are tax implications, as well. There are a few exceptions, but for the most part, the IRS regards forgiven or discharged debt as taxable income. So, if your consolidation loan company negotiates a lower payoff for your debt, you may be on the hook for taxes on the canceled amount. You’ll receive a Form 1099-C, Cancellation of Debt, from the consolidation loan company, and you’re required to file it as income. If you’re already struggling financially, the last thing you need is to owe money to the IRS.
How to Find a Reputable Credit Counselor
You’ll find lots of resources on how to make a budget and get out of debt, both online and from DIY financial planning books. Most of it is good advice, but it may be too late to stop the harassing calls. And it may not be enough to relieve the mounting financial pressure. Be assured that there are legitimate and respectable credit counseling services that can help you recover.
The U.S. Consumer Financial Protection Bureau offers solid tips for finding a reputable firm. Look for non-profit companies that belong to industry oversight organizations. You can find a qualified non-profit credit counseling service near you from one of these agencies:
- The Financial Counseling Association of America (FCAA)
- National Foundation for Credit Counseling (NFCC)
Reputable firms offer free counseling to evaluate your need for their services. You should be able to talk with a counselor face-to-face or over the phone to determine whether they can assist you before paying any fees. As most are non-profit entities, you can also expect to receive free educational packages on budgeting, debt management, and improving your credit score.
Also, look for companies that hire counselors with certification, like those offered by the National Association of Certified Credit Counselors (NACC).
Will Credit Counseling Get You Back on Track?
At first glance, there are no lasting downsides to credit counseling, per se. You can receive help putting together a budget plan that reduces your debt and covers your day-to-day cash needs. Even if you’re not overwhelmed by debt, your credit counselor can help you work on improving your credit rating before you make a big purchase, such as a home or business. You’ll get much better terms on your home loan with a higher credit score. With non-profit agencies, these resources are free to anyone who wants to gain financial mastery.
Whether or not working with a counselor is your best move depends on your unique situation and the steps you take after your consultation. If you can’t stick to the budget or have the wrong kind of debt, a DMP may not meet your needs. They also can’t assist you unless you have a steady source of income. DMPs can also take three to five years to complete, which can seem quite slow.
However, not all counselors will recommend a DMP. A 2012 report from non-profit Cambridge Credit Counseling showed they only recommended that 28 percent of their clients enter a DMP plan. A larger number of clients, 38 percent, were merely given a comprehensive budget plan to follow.
There’s nothing quite as liberating as feeling entirely in control of your finances. For that reason alone, consulting with a trained professional who can objectively provide you with a solid plan is worth considering. It may be difficult to confront your past mistakes when it comes to money management, but if you can honestly assess your weaknesses and develop good financial habits, your credit counselor could be your next best friend.