Debt Relief: What it Is, How it Works, FAQs (2024)

What Is Debt Relief?

Debt relief involves the reorganization of a borrower's debts to make them easier to repay. It can also give creditors a chance to recoup at least a portion of what they are owed. Debt relief can take a number of forms, including reducing the debt, lowering the interest rate on it, or extending the period for repayment, among others.

Creditors are often willing to consider debt-relief measures when the alternative is total default by the borrower. Those eligible for debt relief can range from individuals and small businesses to large corporations, municipalities, and even entire nations. This article focuses on individuals.

Types of Debt Relief Programs

Debt relief can come in a variety of forms. Those include debt consolidation, debt settlement, and bankruptcy. Here is a brief overview of each type and when they may be appropriate.

How Debt Consolidation Works

Debt consolidation involves taking out a new loan or other debt and using it to pay off several existing debts. Typically, the new debt will carry a lower interest rate than the old debts, making monthly payments less expensive.

Even borrowers who aren't facing debt trouble can often benefit from debt consolidation loans. For example, they may transfer theirexisting credit cardbalances to a new card, especially one that charges little or no interest during an introductory period. Or they might take out a home equity loan and use it to pay off their credit cards.

Of course, for borrowers who are deep in debt, obtaining new credit at a good interest rate (or even at all) can be a challenge. If that's the case, you have a couple of options. One is to consult with a reputable credit counseling agency, which can advise you on what kinds of consolidation loans might be available to you and lay out your other alternatives. Credit counseling agencies can often help arrange a payment plan with your creditors, such as one that stretches your debt repayments over a longer period of time.

Another option is to try to negotiate directly with your creditors. As the Consumer Financial Protection Bureau points out, "Some creditors might be willing to accept lower minimum monthly payments or change your monthly due date because they would rather get paid less on a regular basis—than not get paid at all."

How Debt Settlement Works

Unlike debt consolidation, which may not change how much money you owe, the goal of debt settlement is to pay off your debts for a lesser amount, often in the form of a single lump sum.

You can attempt to negotiate with your creditors yourself or hire a debt settlement company to handle some of the work for you. Be careful, though, as this area is rife with fraud. Even legitimate debt settlement companies come with fees and significant damage to your credit score.

As an example of a debt settlement, you might offer to pay a creditor that you owe $10,000 a lump sum of $7,500 (or three $2,500 installments) to settle the debt. It is entirely up to the creditor whether to accept your offer, but they might be inclined to if they believe that the alternative is receiving nothing or if they don't want to go through a long, drawn-out process in order to recoup their money.

Note that if the creditor in question reports transactions to credit bureaus, your settled debt will remain on your credit report for seven years, which can hurt your ability to get credit in the future.

How Bankruptcy Works

Bankruptcy is often referred to as a last resort for getting out of debt, and it can have severe consequences, remaining on your credit report for up to 10 years. Even so, it is the route many Americans ultimately choose. In 2022, for example, there were nearly 388,000 personal bankruptcy filings in the United States.

Most individuals who file for bankruptcy use either Chapter 7 or Chapter 13. Chapter 11 is also available to individuals, but it is generally used by businesses.

In a Chapter 7 bankruptcy, the person's assets, except for certain exempt ones, are sold off by a trustee, who uses the proceeds to pay back their creditors to the extent possible. Most of their remaining debts are then discharged. Chapter 7 bankruptcy can remain on your credit report for up to 10 years.

In Chapter 13, the debtor is allowed to keep more of their assets, but they must agree to a plan to pay off their creditors, typically within three to five years. Chapter 13 bankruptcy can remain on your credit report for up to seven years.

For obvious reasons, many creditors will shy away from doing business with individuals who have declared bankruptcy in the past. However, if they keep up with their bills going forward, they can rebuild their credit over time.

The Bottom Line

When people get into more debt than they can handle, debt relief may be their only way out. However, all forms of debt relief can have negative consequences, which the debtor should try to understand before they proceed.