Debt Relief: Understand Your Options and the Consequences

Debt relief can ease the burden of overwhelming debt, but it's not right for everyone. Here are options to explore. Bev O'Shea Feb 10, 2021

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What’s inside

1. When you should seek debt relief 2. Beware: Debt relief can make things worse 3. Debt relief through bankruptcy 4. Relief through debt management plans 5. Relief through debt settlement 6. Do-it-yourself debt relief 7. What not to do

Find that you're just not making progress on your debt, no matter how hard you try? If that's the case, you might be facing overwhelming debt.

To break free of this financial burden, look into your debt relief options. These tools can change the terms or amount of your debt so you can get back on your feet more quickly.

But debt-relief programs are not the right solution for everyone, and it’s important to understand what the consequences might be.

Debt relief could involve wiping the debt out altogether in bankruptcy; getting changes in your interest rate or payment schedule to lower your payments; or persuading creditors to agree to accept less than the full amount owed.

When you should seek debt relief

Consider bankruptcy, debt management or debt settlement when either of these is true:

You have no hope of repaying unsecured debt (credit cards, medical bills, personal loans) within five years, even if you take extreme measures to cut spending.
The total of your unpaid unsecured debt equals half or more of your gross income.
On the other hand, if you could potentially repay your unsecured debts within five years consider a do-it-yourself plan. That could include a combination of debt consolidation, appeals to creditors and stricter budgeting.

Beware: Debt relief can make things worse

The debt relief industry includes scammers who are eager to take what little money you have. Many people who enter debt relief programs fail to complete them. You could end up with debts that are even bigger than when you started.

But debt relief may give you the new start or the breathing room you need to finally make real progress.

Be sure you understand — and verify — these points before entering any agreement:

What you need to qualify.
What fees you will pay.
Which creditors are being paid, and how much; if your debt is in collections, make sure you understand who owns the debt so payments go to the right agency.
The tax implications.

Debt relief through bankruptcy

There’s little point in entering a debt settlement or debt management plan if you’re not going to be able to pay as agreed. We recommend talking with a bankruptcy attorney first, before you pursue any debt relief strategy. Initial consultations are often free, and if you don’t qualify, you can move on to other options.

The most common form of bankruptcy, Chapter 7 liquidation, can erase most credit card debt, unsecured personal loans and medical debt. It can be done in three or four months if you qualify. What you should know:

It won’t erase taxes owed or child support obligations, and student loan debt is highly unlikely to be forgiven.
It will decimate your credit scores and stay on your credit report for up to 10 years even as you restore your credit history. That’s no small thing, because poor credit history can affect your eligibility for certain jobs, your chances of getting an apartment lease, and how much you pay for car insurance. When your credit is already bad, a bankruptcy may allow you to rebuild your credit much sooner than continuing to try to repay. (Learn more about when bankruptcy is the best option.)
If you have used a co-signer, your bankruptcy filing will make that co-signer solely responsible for the debt.
If debts continue to pile up, you can’t file another Chapter 7 bankruptcy for eight years.
It may not be the right option if you would have to give up property you want to keep. The rules vary by state. Typically, certain kinds of property are exempt from bankruptcy, such as motor vehicles up to a given value and part of the equity in your home, but you usually have to give up a second car or truck, family heirlooms, vacation homes and any valuable collections.
It may not be necessary if you’re “judgment proof,” which means you don’t have any income or property a creditor can go after. The creditors can still sue you and get a judgment, but they won’t be able to collect.

Also, not everyone with overwhelming debt qualifies. If your income is above the median for your state and family size, or you have a home you want to save from foreclosure, you may need to file for Chapter 13 bankruptcy.

Chapter 13 is a three- or five-year court-approved repayment plan, based on your income and debts. If you are able to stick with the plan for its full term, the remaining unsecured debt is discharged. It will take longer than a Chapter 7 — but if you are able to keep up with payments (a majority of people are not), you will get to keep your property. A Chapter 13 bankruptcy stays on your credit report for seven years from the filing date.

Relief through debt management plans

A debt management plan allows you to pay your unsecured debts — typically credit cards — in full, but often at a reduced interest rate or with fees waived. You make a single payment each month to a credit counseling agency, which distributes it among your creditors. Credit counselors and credit card companies have longstanding agreements in place to help debt management clients.

Your credit card accounts will be closed and, in most cases, you’ll have to live without credit cards until you complete the plan. (Many people do not complete them.)

Debt management plans themselves do not affect your credit scores, but closing accounts can hurt your scores. Once you’ve completed the plan, you can apply for credit again.

Missing payments can knock you out of the plan, though. And it’s important to pick an agency accredited by the National Foundation for Credit Counseling or the Financial Counseling Association of America. Even then, make sure you understand the fees and what alternatives you may have for dealing with debt.

Relief through debt settlement

Debt settlement is a financial game of chicken. We do not recommend debt settlement for the vast majority of people. Bankruptcy is almost always a better option; debt settlement is a last resort for those who face overwhelming debt but cannot qualify for bankruptcy.

Debt settlement companies typically ask you to stop paying your creditors and instead put the money in an account they control. Each creditor is approached as the money accumulates in your account and you fall further and further behind on payments. Fear of getting nothing at all may motivate the creditor to accept a smaller lump-sum offer and agree not to pursue you for the rest.

Not paying your bills can result in collections calls, penalty fees and, potentially, legal action against you. Debt settlement stops none of that while you're still negotiating. Expect at least four to six months before the settlement offers begin. Depending on how much you owe, the process could take years.

And the continued late payments further damage your credit score.

You may also face a bill for taxes on the forgiven amounts (which the IRS counts as income). Lawsuits can lead to wage garnishments and property liens.

You can attempt to settle a debt yourself, or you can hire a professional. The debt settlement business is riddled with bad actors, though; the Consumer Financial Protection Bureau, the National Consumer Law Center and the Federal Trade Commission caution consumers in the strongest possible terms.

Some of those companies also advertise themselves as debt consolidation companies. They are not. Debt consolidation is something you can do on your own, and it will not damage your credit.

Do-it-yourself debt relief

There’s nothing to say you can’t borrow from some of the above-listed debt relief options and create your own plan.

You can do what credit counselors do in debt management plans: Contact your creditors, explain why you fell behind and what concessions you need to catch up. Most credit card companies have hardship programs, and they may be willing to lower your interest rates and waive fees.

You can also educate yourself on debt settlement and negotiate an agreement by contacting creditors yourself. (Learn how you can negotiate a debt settlement on your own.)

If your debt isn’t unsurmountable, more traditional debt-payoff strategies may be available. For example, if your credit score is still good, you may be able to apply for a credit card with a 0% balance transfer offer that can give you some breathing room. Or you may find a debt consolidation loan with a lower interest rate.

Those options won’t hurt your credit; as long as you make the payments, your credit score should rebound.

If you go this route, however, it’s important to have a plan that will prevent you from running up your credit card debt again. It also can be hard to qualify for a new card or loan when you are deeply in debt, because that often leads to missed payments or high balances, and those hurt your credit standing.

What not to do

Sometimes overwhelming debt comes with devastating swiftness — a health crisis, unemployment or a natural disaster. Or maybe it came a little at a time, and now creditors and collection agencies are pressing you to pay, and you just can’t.

If you’re feeling overwhelmed by debt, here are some things not to do:

Don’t pay a secured debt (like a car payment) late in order to pay an unsecured one (like a hospital bill or credit card). You could lose the collateral that secures that debt (your car).
Don’t borrow against the equity in your home. You’re putting your home at risk of foreclosure and you may be turning unsecured debt that could be wiped out in bankruptcy into secured debt that can’t.
Don’t withdraw money from your retirement savings in order to repay unsecured debt. This is financial suicide.
Think twice about borrowing money from workplace retirement accounts as well. If you lose your job, the loans can become inadvertent withdrawals and trigger a tax bill, which is the last thing you need.
Don’t make decisions based on which collectors are pressuring you the most; that may lead to actions that aren’t in your best interest. Instead, take time to research your options and choose the best one for your situation.
What Is a Budget?

A budget is a way to balance income, expenses and financial goals for a specific length of time. Lauren Schwahn Dec 18, 2020

What is a budget?

A budget is a spending plan based on income and expenses. In other words, it’s an estimate of how much money you’ll make and spend over a certain period of time, such as a month or year. (Or, if you're accounting for the incoming and outgoing money of everyone in your household, that's a family budget.)

Budgeting can involve making a comprehensive list of expenditures or focusing on a few categories. Some people prefer to write their budget out by hand, while others use a spreadsheet or budgeting app. There’s no correct way to budget — what works for one person might not work for another.

That said, the 50/30/20 budget is one of our favorites. This method suggests you spend about 50% of your monthly after-tax income on necessities, 30% on wants and 20% on savings and paying off debt.

What’s the purpose of a budget?

Budgeting isn’t about depriving yourself; it’s about taking control of your money. Making a budget shouldn’t feel like a punishment. Remember, it’s a plan for all of your money — that includes money for fun stuff, too.

A budget doesn’t have to be rigid. In fact, it should change as your circumstances change — when you get a raise, for example, or become a homeowner. The idea is to make your budget as personalized as possible, leaving room to adapt. Surprises (and mistakes) will happen.

Why is budgeting important?

Budgeting benefits everyone, not just those who struggle financially. It encourages you to live within your means and put your money to work in the best way possible. Think of a budget as a steppingstone to your financial goals. It can help you:

Understand your relationship with money. Tracking your income and expenses paints a clear picture of how much you have to save or spend. Once you spot patterns, you can identify where to make adjustments. Maybe you spend less than you earn (way to go!) but you’re paying for that subscription beauty box that you no longer need.
Save enough for the future. A good budget coaxes you to earmark money for an emergency fund and savings goals like a vacation or retirement.
Get — or stay — out of debt. Mapping out expenses in advance reduces the risk of overspending and can help you pay off debt you already have.
Relieve stress. Budgeting isn’t a cure-all, but it can help you manage financial decisions and prepare for challenges.

How do you start a budget?

Ready to give budgeting a whirl? Start with the basics. That includes outlining your income, account balances and debts, and tracking expenses. Then, identify your priorities and find the right budget system for your needs.

Before you build a budget

Track all your spending at a glance to understand your trends and spot opportunities to save money.

Budgeting 101: How to Budget Money

Divide your income among needs, wants, savings and debt repayment, using the 50/30/20 budget. Bev O'Shea, Lauren Schwahn Jan 13, 2021

If I have take-home pay of, say, $2,000 a month, how can I pay for housing, food, insurance, health care, debt repayment and fun without running out of money? That’s a lot to cover with a limited amount, and this is a zero-sum game.

The answer is to make a budget.

What is a budget? A budget is a plan for every dollar you have. It’s not magic, but it represents more financial freedom and a life with much less stress. Here’s how to set one up.

How to budget money

Calculate your monthly income, pick a budgeting method and monitor your progress.
Try the 50/30/20 rule as a simple budgeting framework.
Allow up to 50% of your income for needs.
Leave 30% of your income for wants.
Commit 20% of your income to savings and debt repayment.

Understand the budgeting process

Figure out your after-tax income

If you get a regular paycheck, the amount you receive is probably it, but if you have automatic deductions for a 401(k), savings, and health and life insurance, add those back in to give yourself a true picture of your savings and expenditures. If you have other types of income -- perhaps you make money from side gigs -- subtract anything that reduces it, such as taxes and business expenses.

Choose a budgeting plan

Any budget must cover all of your needs, some of your wants and — this is key — savings for emergencies and the future. Budgeting plan examples include the envelope system and the zero-based budget.

Track your progress

Record your spending or use online budgeting and savings tools.

Automate your savings

Automate as much as possible so the money you’ve allocated for a specific purpose gets there with minimal effort on your part. An accountability partner or online support group can help, so that you're held accountable for choices that blow the budget.

Revisit your budget as needed

Your income, expenses and priorities will change over time. Adjust your budget accordingly, but always have one.

Before you build a budget

Track all your spending at a glance to understand your trends and spot opportunities to save money.

Frequently asked questions

How do you make a budget spreadsheet?

How do you keep a budget?

How do you figure out a budget?

Try a simple budgeting plan

We recommend the popular 50/30/20 budget. In it, you spend roughly 50% of your after-tax dollars on necessities, no more than 30% on wants, and at least 20% on savings and debt repayment.

We like the simplicity of this plan. Over the long term, someone who follows these guidelines will have manageable debt, room to indulge occasionally, and savings to pay irregular or unexpected expenses and retire comfortably.

The 50/30/20 budget

Find out how this budgeting approach applies to your money.

Monthly after-tax income

Your 50/30/20 numbers:

NECESSITIES

WANTS

SAVINGS AND DEBT REPAYMENT

See your money in one place

NerdWallet tallies up your expenses and shows you how much you’re spending on things like food, bills, travel and more. Plus we’ll show you ways to save big.

Allow up to 50% of your income for needs

Your needs — about 50% of your after-tax income — should include:

Groceries.
Housing.
Basic utilities.
Transportation.
Insurance.
Minimum loan payments. Anything beyond the minimum goes into the savings and debt repayment category.
Child care or other expenses you need so you can work.

If your absolute essentials overshoot the 50% mark, you may need to dip into the “wants” portion of your budget for a while. It’s not the end of the world, but you'll have to adjust your spending.

Even if your necessities fall under the 50% cap, revisiting these fixed expenses occasionally is smart. You may find a better cell phone plan, an opportunity to refinance your mortgage or less expensive car insurance. That leaves you more to work with elsewhere.

Leave 30% of your income for wants

Separating wants from needs can be difficult. In general, though, needs are essential for you to live and work. Typical wants include dinners out, gifts, travel and entertainment.

It’s not always easy to decide. Is a gym membership a want or a need? How about organic groceries? Decisions vary from person to person.

If you're eager to get out of debt as fast as you can, you may decide your wants can wait until you have some savings or your debts are under control. But your budget shouldn't be so austere that you can never buy anything just for fun.

Every budget needs both wiggle room — maybe you forgot about an expense or one was bigger than you anticipated — and some money you're entitled to spend as you wish.

Your budget is a tool to help you, not a straitjacket to keep you from enjoying life, ever. If there's no money for fun, you'll be less likely to stick with your budget — and a good budget is one you’ll stick with.

Commit 20% of your income to savings and debt repayment

Use 20% of your after-tax income to put something away for the unexpected, save for the future and pay off debt. Make sure you think of the bigger financial picture; that may mean two-stepping between savings and debt repayment to accomplish your most pressing goals.

Priority No. 1 is a starter emergency fund.

Many experts recommend you try to build up several months of bare-bones living expenses. We suggest you start with an emergency fund of at least $500 — enough to cover small emergencies and repairs — and build from there.

You can’t get out of debt without a way to avoid more debt every time something unexpected happens. And you’ll sleep better knowing you have a financial cushion.

Priority No. 2 is getting the employer match on your 401(k).

Get the easy money first. For most people, that means tax-advantaged accounts such as a 401(k). If your employer offers a match, contribute at least enough to grab the maximum. It's free money.

Why do we make capturing an employer match a higher priority than debts? Because you won’t get another chance this big at free money, tax breaks and compound interest. Ultimately, you have a better shot at building wealth by getting in the habit of regular long-term savings.

You don’t get a second chance at capturing the power of compound interest. Every $1,000 you don’t put away when you’re in your 20s could be $20,000 less you have at retirement.

Priority No. 3 is toxic debt.

Once you’ve snagged a match on a 401(k), if available, go after the toxic debt in your life: high-interest credit card debt, personal and payday loans, title loans and rent-to-own payments. All carry interest rates so high that you end up repaying two or three times what you borrowed.

If either of the following situations applies to you, investigate options for debt relief, which can include bankruptcy or debt management plans:

You can't repay your unsecured debt — credit cards, medical bills, personal loans — within five years, even with drastic spending cuts.
Your unpaid unsecured debt, in total, equals half or more of your gross income.

Priority No. 4 is, again, saving for retirement.

Once you’ve knocked off any toxic debt, the next task is to get yourself on track for retirement. Aim to save 15% of your gross income; that includes your company match, if there is one. If you’re young, consider funding a Roth individual retirement account after you capture the company match. Once you hit the contribution limit on the IRA, return to your 401(k) and maximize your contribution there.

Priority No. 5 is, again, your emergency fund.

Regular contributions can help you build up three to six months' worth of living expenses. You shouldn’t expect steady progress because emergencies happen, but at least you’ll be able to manage them.

Priority No. 6 is debt repayment.

These are payments beyond the minimum required to pay off your remaining debt.

If you’ve already paid off your most toxic debt, what’s left is probably lower-rate, often tax-deductible debt (such as your mortgage). You should tackle these only after you’ve gotten your other financial ducks in a row.

Any wiggle room you have here comes from the money available for wants or from saving on your necessities, not your emergency fund and retirement savings.

Priority No. 7 is you.

Congratulations! You’re in a great position — a really great position — if you’ve built an emergency fund, paid off toxic debt and are socking away 15% toward a retirement nest egg. You’ve built a habit of saving that gives you immense financial flexibility. Don’t give up now.

If you’ve reached this happy point, consider saving for irregular expenses that aren’t emergencies, such as a new roof or your next car. Those expenses will come no matter what, and it’s better to save for them than borrow.