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Debt

What Is Debt Management and How Does It Work?

Want to hear something crazy? Most of our country is drowning in debt. And we’re not just talking about Washington, D.C. We’re talking about you, your best friend and probably even your next-door neighbors. Somewhere along the way, carrying and managing debt has become the norm. But it shouldn’t be.

Right now, Americans have racked up debt to the tune of over $15 trillion.1 That’s credit cards, car loans, student loans, mortgages . . . you name it. Yikes. If you’re losing sleep over all this, you’re not alone. People with consumer debt (aka nonmortgage debt) are twice as likely to lose sleep over their finances compared to those who are consumer debt-free.2

Usually at this point, many people turn to something called debt management (and we’re not just talking about making a budget and paying your bills here). But listen: A debt management plan (DMP) isn’t really the “help” you’re looking for.

Here’s what you need to know about debt management plans and how to kick debt to the curb yourself.

What Is Debt Management?

Debt management is the process of handling your debt through a third-party negotiator (usually called a credit counselor). This person or company works with your lenders to negotiate lower interest rates and combine all your debt payments into one shiny new monthly payment. Typically, these programs are structured to last roughly three to five years with the goal of paying off your debt.

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You might be thinking: Okay, I'm with you so far. But what kind of debt are we talking about here?

Glad you asked, because your specific debt might not even be eligible under many debt management plans. If you have an outstanding secured loan like a home mortgage, auto loan or any other loan that’s tied to actual physical property (otherwise known as collateral), it won’t qualify for a DMP. Why? Because debt management plans only work with unsecured loans—loans without collateral attached to them.

Here are a few examples of unsecured debt:

  • Credit card debt
  • Personal loans
  • Payday loans
  • Income tax debt
  • Medical bills

So, if your debt falls into the secured loan category, this may rule out DMPs for you from the very beginning. And if that’s true, breathe a sigh of relief. You don’t want one anyway.

How Does Debt Management Work?

Credit counseling companies offer all kinds of ways to “help” you get out of debt—everything from debt management plans to debt management alternatives like debt consolidation. So you have to keep your eyes wide open, because these companies will to try to sell you their services as the “best” or “only” way to get your debt paid off.

But when it comes to DMPs, it all boils down to these three steps:

1. Meet with a credit counselor.

Most debt management programs have credit counselors who work with nonprofit agencies (although there are some for-profit agencies out there too). They’ll act as the middleman to negotiate lower interest rates and fees for all of your unsecured debt and help you create a plan to pay it off.

2. Create a debt management plan.

Your credit counselor will help you create a debt management plan with the hope of paying off your debt in three to five years. How? Again, by negotiating with your lenders to get lower interest rates and waived fees. Some credit counselors are able to negotiate dropped late fees too.

The idea of a DMP is that by “saving” money on interest and fees, you’ll be able to catch up on payments and pay off your debt faster. Every debt management plan is tailored uniquely to your financial situation and how much negotiating your credit counselor is able to do on your behalf.  

3. Pay off your debt (with help).

Now that you and your credit counselor have created a plan of action, it’s time to pay off your debt. But instead of paying your creditors directly, you’ll pay your credit counselor, and they’ll do the dirty work of paying your bills for you. So, to you, it’s one nice lump payment . . . plus fees for the setup and monthly maintenance, of course.

Look, working with a debt management plan isn’t the silver bullet you’re looking for. In fact, it’s not a silver bullet at all. Why? Because it doesn’t address the core problem: the habit of relying on debt to cover expenses instead of creating and sticking to a monthly budget. No matter how you decide to deal with your debt, it’s going to take hard work, patience and time. Lots of time.

How Do Debt Management Programs Impact Your Credit?

Like it or not, America loves the credit score. It’s what lenders use to determine if you’re able to “handle” more debt. That being said, using a debt management program will impact your score as you work to pay off your debt and close your accounts. But how?

Well, your FICO score is made up of five different categories: 35% payment history, 30% amounts owed, 10% new credit, 15% length of credit history and 10% credit mix.3

Not only will you have a note in your credit report that states you’re using a debt management plan, you’ll also see it impact your score depending on how high or low your score is. Since payment history is a big chunk of your overall score, using a debt management plan might actually help your score improve if you’ve had a history of missed payments. But if you have a higher credit score to begin with, you could see your score drop some as you close out your credit cards and use less credit (credit utilization).

Missed Payments

When you miss payments on your DMP (or any payments, really), your credit score takes a hit. Why? Because your payment history makes up the biggest part of your credit score. A good track record of paying your bills on time (without fail) keeps that FICO score real happy.

Credit Utilization

This one is a doozy. If you have a loan or credit card, the credit score industry doesn’t want you charging up to your limit. So, your credit utilization is based off how much of your credit limit you’re actually using. The lower your utilization rate, the better your score will be. When you close a few credit card accounts or pay off loans, your utilization rate goes up and your credit score goes down. This means you have less overall debt but you’re actually using “more” of your total credit limit.  

So, if you have a $5,000 credit limit on two cards (a $10,000 limit combined) and you close one card, you’re technically using more of your limit. It’s a backward concept, but then again . . . so is the credit score.

Disadvantages of Debt Management Plans

The DMP process might seem straightforward. You may be thinking, I get a lower interest rate and someone else handles my debt—what more do I need to know? Well, a bit more. Let's take a deeper look at the problems with a debt management plan.

1. Expect to Work With a Middleman

Put simply, when you enroll in a DMP, you enlist a credit counseling agency to serve as a middleman between you and your creditors. Once hired, they'll attempt to negotiate lower interest rates and more competitive repayment plans on your behalf. But here’s the thing: You're more than capable of taking care of this yourself. All you have to do is pick up the phone and call your creditors.

If you’re trying to avoid bankruptcy, you might be surprised to find your creditors are willing to work with you on a revised repayment plan. Think about it: They want their money just as much as you want to get out of debt. So try working together before bringing a stranger (who may have questionable motives) to the table.

2. Beware of Hidden, Up-Front and Monthly Maintenance Fees

Unfortunately for you, most credit counseling agencies charge an up-front fee just for you to start working with them. And on top of that, you can expect monthly maintenance fees to roll in too. So, even though you may be sending lower monthly payments to your creditors, there's a chance it’ll be offset by these other fees.

3. Expect Fewer Breaks

At this point, you might be wondering: So, what happens if I miss a payment while I'm in the program? That’s a great question. Unfortunately, if you miss just one payment, you could get booted from the program. Plus, you’ll see those interest rates bounce right back up to where they used to be. And your credit score might take a hit too. Worth the risk? That's up to you.

4. Expect to Have Less Control of Your Finances

Ultimately, when you sign up for a debt management plan, you’re letting someone else take control of your finances. And that’s probably the most dangerous thing about DMPs: They do nothing to help you change your spending behavior.

If you really want to take control of your money, you need to change your behavior with money. Listen, personal finance is 80% behavior and 20% head knowledge. Oftentimes, when you consult credit counseling agencies, you’ll slip further and further into debt because agencies don't help you get to the root of the problem—your behavior

So, if you want to get out of debt, you have to own up to your mistakes with money and decide to change for the better—starting today. Only then will you be able to kick that debt to the curb for good.

Debt Management Alternatives to Avoid

Listen, we’re all for getting out of debt, but there’s a few options out there that are a really bad idea.  

Remember: Just because these options are out there, doesn’t mean they’re the best way to get out of debt (and stay out of debt) for good. In fact, here are a few debt management alternatives you should avoid like the plague.

Debt Consolidation

Debt consolidation might seem like a good idea—on the surface. Staring down just one loan versus a handful is way less of a headache, right? But when you consolidate your debt, you’re basically trading one loan for another. And usually, these loans are secured against some fixed assets like real estate, equipment or vehicles you own.

If you think taking out a loan to settle your other loans seems a little, well, backward, we couldn't agree more. Plus, putting up collateral just to refinance means that if you start missing payments, you could lose your home or car! Ouch.

Oh, and in almost every case of debt consolidation, negotiating a lower interest rate means a longer repayment period. That means you’ll be in debt longer than you would’ve been before you consolidated.

The only (and we mean only) time we would recommend debt consolidation is with high-interest student loans through Splash Financial. Why? Because they believe in crushing your debt—especially student loan debt—and won’t charge you any fees.

Debt Settlement

Unlike a debt management program that puts you on a plan to pay off 100% of your loans in full, debt settlement is when a company negotiates with your creditors to pay them less than the total balance you owe.  

But debt settlement can be an extremely lengthy process, and it can end up being extra costly—with some companies charging fees as high as 15–25% of the total debt you're settling. Say you owe $20,000 in consumer debt. That means you could pay an additional $3,000 to $5,000 just to settle!

Plus, you only qualify if you have a history of missing payments. So, if you're on top of your monthly payments, debt settlement will never be in the cards for you.  

Balance Transfer

A balance transfer is another alternative to a debt management plan—but it’s not a good one. With a balance transfer, you’ll sign up for a new credit card (called a balance transfer card) with the hope of escaping your current interest rates.

Many people love this option because, for a very short time, there’s no interest! But remember, that’s just the promotional period. When interest does kick in (and it will), you’ll be paying an arm and a leg—at a variable rate of 11–25%. Yikes. And don’t forget, each balance transfer will cost you anywhere from 3–5% of the amount you’re transferring.

If you miss just one payment on your new card, you’ll also be saying hasta la vista to that 0% interest rate. 

Personal Loans

If you’re thinking about getting a personal loan to help you get ahead on your debt payments . . . think again. Not only will this drag you deeper in debt, it’ll cause more stress and headaches in the long run. Why? Because instead of chipping away at the debt you already have, you’ll have signed up for even more. It might give you temporary relief for your current payments, but it’ll create an even bigger mess.

Just do yourself a favor and say no to personal loans.

How to Manage Your Debt for Good

Now, for the moment you've been patiently waiting for. This is where we reveal the secret to getting out of debt once and for all. Are you ready for it? Are you listening? Here goes: It’s you. Yep, you are the hero of your story. You can manage your debt yourself and pay off every last one, just like millions of other people have, with the debt snowball method:  

  • Step 1: List your debts smallest to largest, regardless of interest rate. Pay minimum payments on everything but the smallest one.
  • Step 2: Attack the smallest debt with a vengeance. Once that debt is gone, take that payment (and any extra money you can squeeze out of the budget) and apply it to the second-smallest debt while continuing to make minimum payments on the rest.
  • Step 3: Once that debt is gone, take its payment and apply it to the next-smallest debt. The more you pay off, the more your freed-up money grows and gets thrown into the next debt—like a snowball rolling downhill.

Repeat this method as you plow your way through debt. The more you pay off, the bigger your snowball gets. And the less you have to worry about missed payments, overdue bills and living paycheck to paycheck.

But look, if you’re overwhelmed with debt, you need to know that you don’t have to walk this road alone. So, instead of going to a credit counselor who will lead you toward bad debt relief options, reach out to a financial coach. Not only will they listen to your situation and help you create a personalized plan for getting out of debt—they’ll walk with you every single step of the journey, like a personal money mentor.

It’s time to face your debt head on and attack it with everything you’ve got. You won’t cross the finish line overnight, but if you stay focused, you will get there.

Learn more about the path to debt freedom with Ramsey+. Inside of a Ramsey+ membership, you’ll have all of the digital content and tools you need to dump debt, save for emergencies, and invest in your future. Plus, you’ll get a free one-on-one call with an incredible financial coach. Start your free trial today.

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.

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