If you are feeling a bit overwhelmed by the seemingly endless "debt help" options available to you (not to mention the amount of debt you have), you are not alone. And if that weren't bad enough, you probably feel like you need a code book to decipher all of the different terminology that gets used to describe the debt relief options available to you...
And the list goes on...
Now, I'm a strong believer that one of the most important steps you can take in the path to eliminating your debts is to educate yourself about all of your options. And only after you have at least a basic understanding of all of your options should you begin to seek debt help from someone else.
First of all, choosing the "right" debt help option (ie. one that suits you and your financial situation) is likely the most critical step in the entire debt elimination process. By choosing the "wrong" option you may be setting yourself up for failure (and even more debt) no matter how persistent and diligent you are at sticking to your plan. Having a good understanding of your options before you begin to seek help will protect you against the possibility of being talked into a debt relief program that simply isn't suitable for you.
Secondly, the most important person on your road to debt freedom is you. Sure there are people who can certainly provide you with debt help and guide you in the right direction, but at the end of the day it will be you that does all the "heavy lifting". By educating yourself starting today, your chances of successfully ridding yourself of debt will increase tremendously.
The first step in your "debt freedom education" is to learn about
all of the different terminology that is used to describe the various
debt elimination strategies that you will come across. We'll start with
the most common debt help solutions and go from there.
Alright, let's get started...
Ask someone about getting out of debt and there is a good chance the
word "consolidation" will usually roll off their tongue. Ask them to
what debt consolidation is and you might get two
completely different answers. And you know what? Both of those answers
just might be correct?
Let me explain.
The term debt consolidation is used to describe two completely different debt help strategies. The first strategy involves "consolidating" all of your existing unsecured debt into one new loan. The second strategy involves the "consolidation" of your monthly debt payments which are made to a credit counselor. Let's look at each more closely.
Debt Consolidation Loan - A more accurate term for the first strategy would be a debt consolidation loan. And chances are that when someone uses the term debt consolidation, they are referring to consolidating debts using a new loan. Here's the basics of how this strategy works.
Let's say that you have five unsecured debts totaling $40,000, (credit cards, medical bills, a signature loan etc.) with an average interest rate of 17%. If you are struggling to make the monthly payments on these debts due to the high interest charges and unfavorable payment structures, one option is to take out a new loan for $40,000 and pay off the existing debt. Of course, in order for this debt help strategy to be helpful, the interest rate on the new loan would have to be less than what you are paying now (say 10%) and the monthly payment amount would have to be smaller. If you can accomplish these, then a new debt consolidation loan may make sense for you.
Debt Consolidation / Debt Management - The second type of debt consolidation is likely the lesser known (or at least lesser understood) of the two consolidation options. The way this debt help option works is completely different than the debt consolidation loan discussed above. The main difference being that it does not involve any new loans or debt. (Which is a good thing by the way.) Here's how it works.
Let's go back to our example from above. You have $40,000 in debt, with five separate creditors, with an average interest rate of 17%. You are struggling to make the monthly payments and you decide that you need some help. Around that time you see an ad for "debt consolidation", promising to help you get out of debt in 3 to 5 years. But when you contact the company you find out that what they are offering is not a loan. Instead, here is what they are offering.
If you sign on with their debt help program, they will negotiate with your unsecured creditors on your behalf in order to reduce or eliminate the interest rates on your debts, eliminate any late fees and/or over-limit penalties, and restructure the monthly payments to fit your budget. Once you start the program, and your new monthly payment amounts have been set, you will then make one "consolidated" payment to the debt consolidation company each month, who will in turn make the necessary payments to your creditors on your behalf. Now instead of making five separate debt payments every month, you only make one payment to the debt help company. The consolidation of these payments is where the term "debt consolidation" comes from.
In addition to working with your creditors to negotiate more favorable terms for you, a good debt consolidation company will also work with you to help you get a handle on your finances, prepare a detailed budget, and teach you about credit, debt and handling money. This is to ensure that you not only get out of debt, but remain that way in the future. In my opinion, this portion of the debt consolidation program (ie. the education and budgeting part) is the most critical to your success.
The objective of the typical debt consolidation plan is to restructure your debts (interest rates, fees and penalties, monthly payment amounts etc.) so that you will be debt free after 3 to 5 years in the program.
Now, before we move on, one other term that you may have come across in researching debt help, is debt management. For your reference, debt management is another term used to describe the second type of debt consolidation we discussed above. In other words, when a company is offering either debt management or debt consolidation, they typically mean the same thing.
For the most part, the terms credit counseling and debt counseling are interchangeable. Most people who seek counseling with respect to their "credit", do so because they are having trouble with "debt". In some countries you will hear the term "debt counseling" more often (U.K. and Canada for example), while in others like the United States credit counseling is the more popular term. As well, due to the different spelling of the word counseling in the U.K., Canada and Australia for example, (it's spelled "counselling" with two "L's") you may come across debt help terms such as debt counselling and credit counselling.
Now that we have that cleared up, what exactly is debt and credit counseling?
As I mentioned above, if you are struggling with your debts and having problems making the monthly payments on them, working with a credit counselor can be an excellent first step in finding a solution. In your initial meeting with your credit counselor (this can be in person, over the phone or over the internet), the first thing s/he will do is conduct a thorough analysis of your financial situation. In order to do this properly you will need to provide them with details on all of your finances. Your income, savings, credit card debts, mortgage or rent information, car loans, utility bills, etc. In other words, you need to share with them anything that comes into or out of your life when it comes to your finances.
Once the debt counselor has this information, they will use it to
help you create a budget which will possibly become the most important weapon in your
fight against debt. A thorough budget can help you on several levels.
First, it can identify areas
of spending which you can reduce.
it can help you become very clear on how much money you can spend each
month and still "live within your means".
Third, it can help you begin
to set aside money for future needs such as your children's college
education, your retirement, and "fun things" like the vacation you would
like to take next year.
Finally, and probably most important if you are struggling with debt, a budget can help you plan out exactly how and when you will get out of debt.
Credit and debt counselors will also provide you with access to educational materials and training to help teach you about handling money and credit so that you can get out of debt faster and stay out of debt in the future.
Unfortunately, even after working with you to organize your finances and prepare a budget, you may still require more debt help than can be provided through debt and credit counselling alone. If this is the case, your credit counsellor will explain to you about other debt help options that may address specific needs that cannot be met by them. One of these options might be debt consolidation/debt management which we discussed above. And if your situation is quite desperate, other options such as bankruptcy and/or debt settlement may be appropriate. Let's take a look at debt settlement next.
Three terms, one meaning.
Such is the case for this debt help option. Debt settlement, debt negotiation and debt arbitration are all used pretty much interchangeably to describe the process of negotiating with your creditors to pay off your debts in one lump sum payment for less than what is owed. The most common term used is debt settlement, so that is how I will refer to it going forward.
No doubt you have seen debt relief ads that claim to get you out of debt for as little as 30% of what you owe, in 18 to 36 months. Well, the service that these debt companies are promoting is consumer debt settlement. What they do is negotiate with your creditors on your behalf, and try and convince them to accept a small (relative to the debt owing that is) lump sum payment now rather than risk not getting anything from you in the future.
Although this may seem like a great option at first (hey, who doesn't want to get rid of their debt for 30 cents on the dollar), a closer look will show you that it is only a suitable for people who are having severe debt problems, and who may be considering filing bankruptcy. Having said that, bankruptcy is a viable and legitimate debt help option for some people.
A few years ago, the bankruptcy laws in the United States were changed, the result of which is that it is now much more difficult to qualify for Chapter 7 bankruptcy. Under Chapter 7 bankruptcy all of your debts (with the exception of IRS tax debts and federal student loans) are discharged, and your assets liquidated in order to pay creditors. Under the new laws, many folks only qualify for Chapter 13 bankruptcy or as it is also known, "wage-earner" bankruptcy.
What does this mean to you? Perhaps a lot. Let's take a quick look at both Chapter 7 and Chapter 13 bankruptcy as sources of debt help.
Filing Chapter 7 Bankruptcy
When most people think of bankruptcy, they think of losing all of their assets, but at the same time, ridding themselves of all of their debts, giving them a fresh financial start. Although this is not exactly accurate, for the most part this is what happens when you file Chapter 7 bankruptcy. Chapter 7 is also referred to as "liquidation bankruptcy" because when you file you are required to liquidate (most) of your assets.
When the bankruptcy laws changed a few years back, it became much more difficult for people to actually qualify for Chapter 7. And if you need debt help and you can't qualify for Chapter 7 bankruptcy, you may have to consider Chapter 13 bankruptcy.
Filing Chapter 13 Bankruptcy
Chapter 13 bankruptcy is often called "wage-earner" bankruptcy. Under this type of "reorganization" bankruptcy, you are allowed to keep your property, but you must agree to repay all or part of your debts over the next 3 to 5 years through monthly payments. If you earn an income, and that income is under a certain level per month, then you can potentially qualify for Chapter 7 bankruptcy. Otherwise, your only option for bankruptcy is Chapter 13.
Now, this is not to say that Chapter 13 is your only debt help option. In fact many people who cannot qualify for Chapter 7 bankruptcy, opt to settle their debts through a debt settlement program rather than filing Chapter 13 bankruptcy.
Credit Score - Your credit score is a number that is based upon the details of your credit report. Lenders use this score in their evaluation of you to determine how much of a risk it would be to lend you money. The most common credit scores are FICO scores. The lower your FICO score, the more difficult it is to get credit, and the higher the interest rate you will pay on that credit.
Credit Report - Your credit report contains your current and historical credit information as reported to the credit bureaus by your creditors. Your report details things such as the type of credit you have (ex. a credit card), the amount of credit you have, whether or not you pay your debts on time, and other details. Lenders (and other people like potential employers and landlords) will use this information in addition to your FICO score in order to help them make lending decisions regarding you.
Credit Repair - As you can imagine, not everything that shows up on your credit report reflects on you (and your credit) in a positive way. Things like charge-offs, late payments, and collections can pull down your credit score and cost you in terms of higher interest rates. By having these "negative" items removed you can significantly increase your FICO score and "repair" your broken credit.
If you are currently carrying credit card debt at high interest rates, you may have heard about using 0% credit cards and/or credit card balance transfers to lower your interest rates and monthly payments. The idea itself is fairly straight forward and is based on a similar debt help premise as a debt consolidation loan.
To implement this debt help strategy you would apply for (and get) a new credit card with a lower interest rate than the credit card(s) you currently hold. (In some instances you can get new credit cards that have very low or even 0% interest rates for introductory periods ranging from three to eighteen months.) By "consolidating" your credit card debt onto the new card you can save yourself a significant amount of interest. Of course, in order to be truly effective, this technique, like almost all other debt help techniques, must be combined with a detailed personal or family budget that you stick to.
The debt help strategies and techniques that we have discussed so far have focused mainly on unsecured debts like credit cards and personal loans. So to finish off our discussion, let's take a brief look at some techniques to help lessen your monthly mortgage payments. The first technique, mortgage refinance, has been in use for a long time. The second technique, loan modification, although not new, has certainly become more mainstream recently.
Mortgage Refinance - Refinancing your mortgage involves getting a brand new mortgage to replace your existing mortgage. Of course, the main incentive for doing this is to secure a lower interest rate than you are currently paying. Another reason people refinance is to stretch out the amortization period of the mortgage (the length of time to pay off the mortgage). Doing this is a double edge sword however. On the one hand your monthly payments will go down, making it easier to handle your debt load. On the other hand, it will take you that much longer to pay off the mortgage and it could also increase the amount of interest that you pay in the long run.
Loan/Mortgage Modification - Unlike a mortgage refinance where a new loan is obtained complete with new terms, a mortgage or loan modification involves making changes to the terms of your existing mortgage/loan. These modifications are typically only available to people who show an inability to make the loan payments under the current terms. Some examples of modifications that can be implemented are:
As I said earlier, the more you educate yourself before
seeking debt help from someone else, the more likely you will end up
choosing the best option to suit your situation, and the more likely
that you will be successful in your goal to become debt free. Need a
good place to start? Try this article which lays out a complete list of
your options for getting out of debt.