Credit Counseling vs. Debt Relief: Which Is Right for You?

Americans now owe nearly $5 trillion in non-housing debt, according to the Federal Reserve Bank of New York, a sum that’s increased more than 60% over the past decade. As our debt has grown, so has the burden on individuals trying to pay off their balances. If you're currently struggling with major debt and weighing your options, you're not alone.

Credit counseling and debt relief are two options that could help alleviate your burden. Here’s what to know about credit counseling vs. debt relief, how each works, and which one could be the better choice for you.

Credit counseling can help you manage your finances

Credit counseling involves working with an organization or company to create a plan that helps improve your financial situation. Both for-profit and nonprofit credit counseling options exist. Generally, non-profit credit counselors are the better option, as they’re focused on serving the public rather than generating a profit.

Credit counselors offer many different services, including guidance and assistance with budgeting, building credit, debt consolidation, and creating debt management plans (also called DMPs). These plans provide a strategic roadmap for budgeting and repaying credit card debt and other unsecured loans over a set period, often three to five years.

Once a debt management plan is set up, you’ll typically make a monthly payment to your credit counseling service, which uses that money to repay your balances. It will also work with your creditors on your behalf to negotiate fees, terms, and interest rates to help make your payments more affordable.

How does credit counseling work?

Nonprofit credit counselors offer some guidance and services for free, but they usually charge fees for debt management plans. For instance, you might pay an initial setup fee of around $30 and monthly fees of up to $79. That said, maximum fees vary by state, so you could end up paying significantly less than that.

Besides potential fees, the barriers to entry for debt management plans are fairly low. “Because a debt management plan isn’t a loan, you won’t need to meet credit requirements to qualify,” says Josh Richter, founder and senior debt advisor at FaithWorks Financial, a debt settlement company. “This makes it a much more accessible solution than traditional debt consolidation loans.”

While barriers to entry are low and credit counseling has its positives, it also has potential drawbacks. You may need to close existing credit cards, for example, so you can focus on your current monthly payments and avoid new debt. Closing cards could harm your credit score temporarily, as it’ll reduce your available credit and affect your total credit utilization. And while credit counselors can negotiate with creditors to lower your monthly payments, they aren’t able to reduce how much you actually owe.

Finally, to get the full benefits of working with a credit counselor, you have to actually stick with your debt management plan for several years. In fact, completion rates may vary by individual credit counseling organizations, so it’s a good idea to ask them what the success rate is. For example, Money Management International reports that about three-quarters of clients who start a debt management plan complete the program.

Debt relief involves settling your debt for less than you owe

Debt relief, sometimes called debt settlement or debt negotiation, is generally a more serious intervention than credit counseling. Candidates for debt settlement often have significant, unmanageable, unsecured debt. Debt relief involves negotiating with your creditors to get them to accept payments for less than what you owe. You can pursue this on your own, but it can be a lengthy (and intimidating) process, so many people opt to work with debt relief companies. In these debt relief programs, negotiations usually happen over a period of two to four years.

While settling your debts for less than you owe seems ideal, there are no guarantees a debt settlement company can deliver. It can negotiate on your behalf, but that doesn’t mean your creditors will be willing to reduce your balances. One study found these negotiations are successful about 55% of the time.

How does debt relief work?

Most debt relief companies require clients to enroll a certain amount of debt, with typical minimums from $7,500 to $10,000. But the typical client has much more – about $25,000, according to the American Association for Debt Resolution.

When you pursue debt settlement, the company you work with will typically recommend that you stop making payments to your creditors to build leverage. At the same time, you’ll make monthly deposits into a special savings account. (The debt relief company will recommend how much you need to deposit based on your debt, income and timeline). If the company succeeds in getting a creditor to accept a lower payment, it’ll have you approve that settlement, and then money in the special savings account will then be used to repay that debt. This is where the fees come in: Debt settlement companies charge between 15% and 25% of the total debt you enroll with them. It’s illegal for the companies to charge this fee until they’ve secured a settlement.

Being late on payments is typically a requirement for creditors to agree to settle, but delinquency will hurt your credit score. So debt settlement is usually a better option than credit counseling only if you’re already behind on payments. Alternatively, you could keep making payments when you can and attempt to negotiate debt settlements independently with your creditors instead of working with a company.

There are also some tax drawbacks with debt settlement, says Ashley Morgan, debt and bankruptcy attorney at Ashley F. Morgan Law, PC. “The IRS considers any amount of debt forgiven as income, so you’ll be taxed on it. Your creditor will issue a 1099-C for the forgiven portion, and you’ll need to include the amount on your returns.”

Credit counseling vs. debt relief: Which is right for you?

Credit counseling and debt relief can both help alleviate your debt burden, though each does so differently. Credit counselors can help you budget and potentially reduce your monthly payment by negotiating interest rates, fees and terms with your creditors. Debt relief is a more serious intervention that’s best for people who have significant debt, particularly people who've experienced hardship like job loss, divorce, or a medical emergency.

When credit counseling might be better

Credit counseling is generally a better choice than debt settlement in the following instances, as it can have a less harmful effect on your credit.

• You’re struggling with payments but keeping up with them, or aren’t too far behind.
• You’re willing to close existing credit cards and commit to a budget for a few years.
• You can afford the monthly fees for a debt management plan.
• You want to maintain or build your credit.

When debt relief might be better

Debt settlement might be the better option in the following cases, but keep in mind that it could hurt your credit.

• You’re already significantly behind on payments due to a financial hardship.
• You have over $7,500 in unsecured debt – such as credit card debt, personal loans, or medical bills.
• You feel that getting out of debt is a more immediate concern than protecting your credit.
• You can afford the monthly deposits into the debt settlement program (these are often lower than your minimum monthly payments).
• You want to avoid bankruptcy.
• You understand the risks and tax implications.

More from Money:

5 Things People Get Wrong About Debt Relief

A 4-Step Guide to Negotiating Credit Card Debt

Struggling with Debt? Here Are Your Options to Get Things Under Control