How Do Debt Consolidation Programs Work? - Experian (2024)

What Is a Debt Consolidation Program?

Debt consolidation programs aim to help you pay down your debt more effectively. While each type of program works differently, they can all help you simplify your repayment plan and reduce your costs.

If you're considering a debt consolidation program, it's crucial to understand your situation and the advantages and disadvantages of each option to determine which one is right for you.

Debt Management Plan (DMP)

How it works: A debt management plan is arranged by a credit counseling agency to help you pay off unsecured debts, particularly credit card balances. The agency can negotiate lower interest rates and monthly payments and potentially get certain fees waived. You'll make one monthly payment to the agency, which in turn pays your creditors. DMPs typically last between three and five years.

Key benefits:

• Can make your monthly payments more affordable
• Doesn't require a credit check
• Can reduce your interest costs and bring past-due accounts current
• Credit counselors can offer additional financial advice and support

Key drawbacks:

• Not all debts are eligible
• Your creditors may close your credit card accounts
• You'll have limited access to credit during the program
• Agencies often charge setup and monthly fees

When to consider this program: A DMP can be a good choice if your credit isn't good enough for a lower interest rate on a debt consolidation loan, or if you're starting to fall behind on payments due to budget constraints.

Debt Consolidation Loan

How it works: A debt consolidation loan is a personal loan used to pay off other debts—especially high-interest debt like credit card balances. You can pay off one or more debts with a single loan, and if your credit score is in good shape, you may even be able to secure a lower interest rate and monthly payment. Personal loan repayment terms typically range from one to seven years.

Key benefits:

• Can combine multiple monthly payments into one
• Can help you save money
• Can help you pay off your debt faster
• Repayment terms are flexible

Key drawbacks:

• Some lenders charge upfront origination fees
• Good credit is required for low rates
• Extending your repayment plan can cost you more
• Could tempt you to rack up more debt on paid-off accounts

When to consider this program: A debt consolidation loan is worth considering for people with good credit or better because they'll have a better chance of qualifying for better terms. Because this program doesn't require you to close paid-off credit cards, it may not make sense unless you're committed to changing your spending habits. Other debt consolidation options include a balance transfer credit card, a home equity loan and a home equity line of credit.

Debt Settlement

How it works: Debt settlement is an arrangement between you and a lender or collection agency in which you settle a debt for less than what you owe. The remaining balance is then forgiven. You may try to negotiate a settlement on your own or work with a debt settlement company or law firm to negotiate on your behalf.

Key benefits:

• Can provide relief in a dire financial situation
• Can help you avoid bankruptcy
• Can prevent other consequences, such as lawsuits and wage garnishments

Key drawbacks:

• The forgiven debt is typically considered taxable income
• Working with a debt settlement company can be costly
• Can cause significant damage to your credit score
• There's no guarantee the creditor will work with you
• Typically requires a lump-sum payment, which can take time to amass

When to consider this program: Due to the negative impact debt settlement can have on your credit, it's best to consider it only if you're already behind on debt and facing steeper consequences. It's particularly worth looking into if your only alternative is filing for bankruptcy.

Who Offers Debt Consolidation Programs?

Your options for debt consolidation will vary depending on the type of program you're considering:

• Debt management plans: DMPs are exclusively offered by credit counseling agencies. Your best bet is to work with a nonprofit agency, which you can find through the National Foundation for Credit Counseling or the Financial Counseling Association of America.
• Debt consolidation loans: If you're interested in a personal loan, balance transfer card or other type of consolidation loan, you'll have plenty of options from banks, credit unions and online lenders.
• Debt settlement: Debt settlement companies and law firms can help you negotiate a settlement with your creditors, acting as a middleman for a fee, or you can try to negotiate directly at no extra cost.

In every case, be wary of scams and promises that sound too good to be true. Fraudsters prey on borrowers who are desperate for help, and there have been many cases of individuals and companies taking debtors' money without offering any real service in return.

Does a Debt Consolidation Program Hurt Your Credit?

DMPs and debt consolidation loans can ding your credit scores in the short term, while debt settlement can cause lasting and severe damage to your credit profile. In all cases, however, consolidating debt can provide a foundation to work on improving your credit over time.

With that said, here's a quick summary of what to expect with each type of debt consolidation program:

• Debt management plans: A DMP doesn't have a direct impact on your credit, but the program may lead to an initial drop in your credit scores when you close your credit cards: Reducing your available credit will cause your credit utilization rate to spike. However, your credit scores may increase as you pay down your balances on time.
• Debt consolidation loans: Applying for a new loan can ding your credit score slightly due to the hard inquiry that will appear on your credit report. Opening a new account might also negatively impact your length of credit history and thus your credit score. However, paying off credit card debt can reduce your utilization rate, helping your credit scores, and on-time payments can improve your credit over time.
• Debt settlement: The debt settlement route will often hurt your credit, as you're advised to stop paying your bills and let your accounts go past due. It could also take a long time to recover if your accounts go into default, are charged off or sent to collections. The negative mark will remain on your credit reports for seven years from the original delinquency date.

Protecting your credit is certainly important as your credit can impact many aspects of your life. With this in mind, a DMP or debt consolidation loan could be best for your credit as they make it easier to repay your bills on time rather than encouraging you to fall behind.

Are Debt Consolidation Programs a Good Idea?

A debt consolidation program can be a good way to tackle your debt in a more effective way, but it ultimately depends on your current situation and your financial goals.

For example, if you want to pay down your debt faster but your situation isn't dire, you may consider avalanche and snowball repayment strategies to reduce your credit card debt instead of applying for a loan.

However, if your budget is tight and you're facing the possibility of falling behind on payments—or you've already started missing some—a debt consolidation program can be a great way to dig yourself out of a hole and avoid making matters worse.

If you're considering debt consolidation as a way to tackle your debt, think carefully about your situation and goals. Even if you don't plan to do a DMP, many nonprofit credit counseling organizations also offer free debt and budgeting counseling with trained counselors who can help you determine how to proceed.

Staying the Course While Paying Off Debt

Paying off debt can require means and motivation. A debt consolidation program can help by simplifying your bills and lowering your monthly payments. But even then, it can often be a stressful and time-consuming process that takes years to complete.

There's no shortcut, but you can look for ways to save money and put the extra funds toward your bills. Also, be sure to monitor your credit score regularly to keep track of your progress and evaluate your options for managing your debt in the future.