When it comes to managing your debt there are a lot of repayment strategies to consider when your debt becomes overwhelming. Two very common options are debt consolidation loans and debt management plans. Both of these debt management solutions can help to ease the burdens of having multiple financial obligations to pay each month. However, it is important to understand how debt management plans work versus how debt consolidation loans work to help you decide which option is a best fit for your financial situation.
What is a Debt Management Plan?
A debt management plan (DMP) is a payment plan set up for you by a credit counseling agency that helps you repay your debts by negotiating with creditors to reduce or waive fees, finance charges, or interest rates to lower your monthly obligations to ensure repayment. How a debt management plan works is each month instead of paying all of your creditors individually, you deposit your payments into an account with the credit counseling agency. The agency then makes the newly negotiated payments on your behalf to each of your creditors until each debt is paid off in full. Debt management plans are generally used for paying off unsecured debts, such as credit cards, medical bills, utility bills, personal loans, or student loans.
What is a credit counseling agency? Credit counseling agencies are nonprofit organizations with certified counselors that can advise you on credit management, budgeting, and can help you develop a financial plan, which often includes a debt management plan and financial education programs.
It is important to understand that a debt management plan is not a loan, nor is it the same thing as debt settlement; you are still paying off your individual creditors in full, over time but through the help of the credit counseling agency. There is typically a monthly fee of up to $50, involved with a debt management plan. Each agency will have a different fee structure, so you will want to inquire about those fees before you commit to their program. You should have a full understanding of the charges you will be required to pay throughout the entirety of the program.
Additionally, keep in mind your creditors do not have to work with the credit counseling agency to negotiate different terms or waive fees. This means if any of your creditor’s opt-out of your debt management plan, then you will still be responsible to pay them on your own. The debt management plan will only be helpful to you if the majority of your creditors agree to work with the credit counseling agency, which is typically not an issue when you work with a trustworthy agency.
When to Use Debt Management Plans
To determine if a debt management plan could effectively help you gain control over your financial situation there are several factors to take into consideration:
- Look at your debt-to-income ratio (DTI). If your DTI is above 20%, excluding your mortgage, then this is a sign that your debt level is too high and a debt management plan is something you may want to seriously consider.
- If your credit score is below 620, then a debt management plan may be your best option. This is because many lenders will not extend credit to those with a lower credit score, so you may not qualify for other debt management options like a consolidation loan or balance transfer.
- Debt management plans are also most helpful if you have multiple debts from multiple different creditors to make payments to every month. If you have a smaller number of creditors or have multiple loans with a single financial institution you may be better off working directly with the creditors yourself to avoid the fees associated with a debt management program.
- If you are not seriously behind on your payments a debt management plan can be useful. However, if most or all of your debts are in third-party collections, then you may need to look more closely into bankruptcy or possibly debt settlement.
The criteria listed above for determining if a debt management plan is best for your situation is only a rule of thumb and not a hard guideline. Debt management plans can be helpful to stop your creditors from calling you looking for their payments, and get you headed in the right direction for a better financial future. However, make sure you fully understand what the specific credit counseling agency you choose to work with is offering you and at what cost. At the end of the day, you are still paying off your debts over a period of time so make sure you can afford to do so.
What is a Debt Consolidation Loan?
A debt consolidation loan is simply refinancing your existing debts. It allows you to pay off your debts in full by rolling over high interest rate loans and unsecured debts into one single loan; you then make payments to that one loan each month. Typically after you have consolidated your debt with an unsecured loan you have a smaller monthly payment due to a considerably lower interest rate. You can pay off a wide variety of debts with a debt consolidation loan including: credit cards, medical bills, gambling debts, legal debts, pay day loans, and even some secured debts, like auto loans, as well.
Debt consolidation loans are available through most credit unions and banks as a tool to manage your debts, however there are also specific agencies that deal exclusively in debt consolidation. Each financial institution will have different guidelines for lending. Meaning if you get turned down at one, don’t give up and try another financial institution. However, if you have talked with several lenders and none of them can extend you credit, it may be time to consider other debt management solutions.
When to Use a Debt Consolidation Loan?
It is best to use a debt consolidation loan when you begin to struggle to make all of your monthly payments on time every month. However, you do not want your payments to become too far behind for too long as this can damage your credit score to the point where many lenders may not work with you for a consolidation. To help you determine if a debt consolidation loan is right for you, you’ll need to review your finances and ask yourself these questions:
- Will the interest rates be lower on your debt consolidation loan than the average interest rate you are currently paying on the debts you plan to consolidate?
- Will there be a decrease in the total amount of time to pay off your debts with a debt consolidation loan than if you paid down each debt individually?
- Will your total monthly payment decrease with a debt consolidation loan when compared to paying all of your currently monthly obligations individually?
- How will your credit score be affected by debt consolidation loan versus continuing to pay your debts down individually overtime?
The best way to find the answers to these four questions is to gather all of your account statements and bills you want to have included in a debt consolidation loan. Then use a debt consolidation calculator, like this one, to determine whether or not you will save money on interest paid, monthly payments, or if your time to payoff will be faster. To determine how your credit score will be affected, it is recommended that you meet with a trusted financial advisor to review your specific situation. In some cases depending upon the types of debt you plan to consolidate, your credit utilization, or if you plan to close any credit lines after consolidation your credit score could actually decrease. Since everyone’s financial situation is unique it is important to completely understand how a debt consolidation loan will affect for financial picture long term.
Comparing Debt Consolidation Loans and Debt Management Plans
Now that we have explored what a debt management plans is and what a debt consolidation loan is, it’s time to explore some of the differences and similarities between them more closely. Each of these options has very similar benefits when it comes to managing your debt:
- Make one payment to one place
- Lower monthly payments
- Lower interest rates
- Faster time to pay off debt
- Improvements to your credit score
- Stops collection calls
These are all good things that can help ease the burden of managing multiple debts owed to multiple creditors. However, it’s important to remember that with each of these two plans you will still need to have the necessary funds available to cover the monthly payments. If you fail to make payments on time there will be negative consequences. With a debt management plan, if you miss a payment, you risk being removed from the plan entirely and your creditors may increase your rates or re-impose fees they had agreed to waive under the plan. As far as debt consolidation loans, if you miss payments, your credit score will suffer greatly which will make it more difficult to secure financing in the future.
In both cases it is important you do not take on new credit lines or new credit, while you are paying down your debts. You may also be required to close credit lines completely once paid off to ensure you don’t fall back into debt again. If this is a concern for you, a debt consolidation loan maybe the better option, because in many cases you will have more freedom to choose to keep credit lines open. It will also be essential for you to come up with a budget to keep you financially on track in the future. This is where a debt management plan can be more helpful that a debt consolidation loan in some cases, because the credit counseling agency will help you develop a budget as part of your plan.
If you are struggling to make your payments every month, both debt consolidation loans and debt management plans can help you regain control over your financial situation. It is important to know how each of these options works in order for you to be able to make an informed decision about your next steps. Debt management plans and debt consolidation loans offer similar advantages, so it really comes down to which option is going to reduce your monthly payments to the most affordable level.