Debt Management Plan: Understanding How It Works
Key Takeaways:
Credit counselors offer debt management plans to assist individuals in overcoming debt.
DMPs are debt consolidation programs that simplify and expedite debt repayment.
Successful implementation of a DMP hinges on the affordability of the monthly payment.
Eliminating debt is no easy task, often leaving individuals feeling trapped and hopeless. However, it is possible to achieve debt freedom with effective debt management strategies or professional assistance. By understanding the concept of debt management and its potential to restore financial stability, you can regain control of your finances.
What is Debt Management?
Debt management, at its core, involves effectively managing your debts by paying them on time, keeping balances within reasonable limits, and ultimately eliminating those balances.
Debt management can also refer to a specific debt relief approach called a debt management plan (DMP). Consumer credit counseling agencies utilize DMPs to help individuals pay off their debts within a specific timeframe. We will delve further into debt management programs later.
What is a Debt Management Plan?
Debt management plans, also known as debt management programs, are provided by consumer credit counseling agencies. These programs aim to streamline your debt repayment strategy and help you become debt-free within a designated period, typically two to three years, depending on the amount of debt you have.
Here's how a debt management plan operates:
You agree to cease using your credit cards and credit lines and avoid opening new accounts until the completion of your debt management program. Most likely, you will be required to close most, if not all, of your cards.
Your credit counselor negotiates with your unsecured creditors, such as credit card issuers, to lower the interest rates on your debts. In some cases, certain fees may be waived, or your accounts may be brought up to date, ceasing late reporting to credit bureaus.
You make a monthly payment into the plan, which your counselor distributes among your creditors.
Participating in a DMP does not directly impact your credit. Neither your creditors nor your credit counselor reports your involvement in a DMP to credit bureaus. However, your credit score may improve if a creditor brings your account up to date. It may temporarily decrease when you close accounts due to reduced available credit. If you successfully complete your debt repayment, your overall financial health and credit scores should improve in the long run.
Fees for debt management plans may vary. Nonprofit credit counseling agencies or individuals with limited income may qualify for free services. In other cases, there may be a setup fee and a small monthly fee associated with being on the DMP.
Alternative Strategies for Debt Management
Not everyone requires a DMP. If you have sufficient income and a decent credit rating, there are alternative options available. The initial step in managing your debts is to gain a comprehensive understanding of your financial landscape: How much do you owe? What are the monthly payments? When are the payment due dates? What interest rates are you currently paying?
Compile a list of all your debts (spreadsheets can be useful) to gain a comprehensive view. Include the creditor's name, current balance, interest rate, monthly payment, and monthly due date for each debt. If it's a loan with a specific term, include that information as well. From there, follow these steps:
Create a budget
Effective budgeting plays a crucial role in debt repayment. Start by calculating your total monthly income after taxes. Next, list your monthly expenses, including rent, groceries, insurance, dining out, minimum debt payments, utilities, entertainment, and more. Separate the necessary expenses and minimum debt payments from nonessential expenses.
Analyze your past bank statements to determine how much you spend in each category. Financial experts generally recommend allocating no more than 50% of your income to necessities, 30%
to nonessentials, and dedicating 20% to savings or debt repayment. Does your spending align with these guidelines? If not, look for areas where you can cut back (eliminating an expense like cable or using public transportation, for example). If you can reduce expenses, commit to directing those extra dollars toward debt repayment.
Ultimately, you should have a clear idea of your available funds for debt repayment each month. If your income or expenses change, revisit your budget and make necessary adjustments. It's a good practice to reassess your budget every few months to ensure you stay on track.
Quick tip: If you prefer automated budgeting, consider using budgeting apps such as Mint, YNAB, Stash, or Personal Capital. These apps link to your checking account, automatically track your spending, and can send alerts if you exceed your budget.
Accelerate debt repayment
Next, prioritize your debts. The two common strategies are the snowball method, focusing on the smallest debt first, and the avalanche method, prioritizing the debt with the highest interest rate.
The snowball method provides small victories that keep you motivated, while the avalanche method saves the most on interest. The appropriate strategy depends on your total debt amount, interest rates, and personal motivation to pay off debts.
Remember: Even with your chosen strategy, continue making minimum payments on all your debts. Any extra money should be directed toward either the debt with the highest interest rate (avalanche method) or the smallest balance (snowball method).
Set up automatic payments or reminders
Once you have identified your priority debts, establish automatic payments with your creditors. This ensures adherence to your debt repayment plan and prevents late payments that can harm your credit score.
If you are concerned about having sufficient funds in your bank account for auto payments, set up payment reminders instead. You can use Google Calendar or set alarms on your phone for specific dates and times each month. Include the amount you are sending to each creditor to ensure accuracy.
Consider debt restructuring
Another option to make debt repayment more manageable or affordable is to restructure your debts.
Debt restructuring may involve the following approaches:
Debt consolidation: This entails using a loan to pay off all your balances, consolidating them into a single loan. The new loan may offer better terms, such as a lower interest rate or more favorable repayment conditions.
Debt refinancing: Refinancing involves taking out a new loan to pay off an existing one. The new loan may come with improved terms, such as a lower interest rate or an extended repayment period.
Balance transfer cards: By transferring one or more credit card balances to a new card with a zero-interest introductory period (usually six to 24 months), you can aim to pay off the balance before the promotional rate expires.
Home equity products: Homeowners can leverage home equity loans, HELOCs (Home Equity Lines of Credit), or cash-out refinancing to pay off their debts. These options often have lower interest rates compared to most loans and credit cards.
If you are considering these strategies, it is advisable to consult a financial advisor to ensure they align with your specific circumstances.
Seek professional assistance
Lastly, if you are struggling significantly to pay off your debts, do not hesitate to seek professional help. Falling behind on payments or having accounts sent to collections can make it even more challenging to regain control and pay off your debts. Contact a credit counselor or debt relief professional as soon as you feel overwhelmed and have lost control of your finances.
