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Why debt management plans don't work for everyone

Debt management plans are touted as an alternative to bankruptcy and an affordable way to pay back credit card debt. But bankruptcy is sometimes a better choice, and dropping out of a plan can have serious consequences. 

Nonprofit credit counselors are the good guys in the debt relief industry, which is otherwise full to bursting with lies, scams and sketchy players.

That said, credit counselors need to acknowledge that their signature offering 鈥� the聽聽鈥� doesn鈥檛 work for everyone.

Debt management plans are touted as an alternative to bankruptcy and an affordable way to pay back credit card debt. Borrowers make payments to the counseling agency, which then pays the creditors. Thanks to standing agreements that counselors have with credit card companies, the plans typically reduce the interest rates, fees and payments that borrowers are expected to make. Full repayment of the debt often takes four to five years.

If borrowers make all the payments and repay the principal completely, debt management plans have much less impact on their credit scores than other types of debt relief.

Francine Bostick, a Manhattan, Kansas, woman who paid off more than $120,000 in credit card debt in 2012, says she emerged with credit scores good enough to buy her first-ever new car.

鈥淚t was exciting and made me a little nervous when they did the credit check,鈥� says Bostick, 66. 鈥淲e got 0%聽interest for the life of the loan.鈥�

Yet Bostick is also an example of what may be wrong with credit counseling. Some consumer advocates were appalled when the聽named Bostick and her husband, Jim, as the agency鈥檚 2012 鈥淐lients of the Year鈥� because of the couple鈥檚 age and the fact that he had been diagnosed with Alzheimer鈥檚 disease. Bostick worked 12-hour days to earn the money to make debt payments while caring for her increasingly incapacitated husband, who died in May. Critics say the Bosticks should have been encouraged to file bankruptcy so Francine could spend more time with her husband and use any extra money to shore up her own retirement savings.

Bostick says her credit counselor told her she could file for bankruptcy, but Bostick didn鈥檛 consult a lawyer about that option.

鈥淚 still feel we made the right decision for us,鈥� says Bostick. 鈥淚 believe if we had filed bankruptcy I would probably be in the same boat as a few people I know 鈥� who filed bankruptcy聽and are buried in debt again.鈥�

The lack of disclosure about bankruptcy鈥檚 potential benefits isn鈥檛 the only problem with debt management plans.

Other issues include:

• They aren鈥檛 designed to tackle many other types of debt, such as mortgages, car loans, student loans and most medical bills.
• Borrowers should expect to live without much access to credit during the repayment period. Their credit card accounts are typically closed and they agree to not apply for new credit, whether it鈥檚 for another card, a new car or a mortgage refinance. A new account appearing on their credit reports may lead creditors to cancel the debt management agreement.
• There鈥檚 little leeway for missed payments, which can lead to the plan鈥檚 cancellation.

Some people find that they simply can鈥檛 afford the payments on debt management plans, while others drop out because of setbacks such as job loss or unexpected expenses.

That is reflected in newly released data by the NFCC. Of the people who enrolled in its debt management plans in 2010, 42% had completed repayment by the end of 2014 and 12% were still making payments, says Bruce McClary, the spokesman for NFCC, the largest and oldest nonprofit聽.

The foundation is trying to boost its success rate in two important ways: by making payment plans more flexible and by adding a savings component, says Susan Keating, NFCC鈥檚 president and chief executive.

The Washington, D.C.-based foundation intends to offer three repayment options based on clients鈥� ability to pay, rather than the current one-size-fits-few option that critics call too rigid. Each option would allow clients to put money aside for emergencies, Keating says. Traditionally, creditors wanted every possible dollar to go to them, which can impede the ability of debt management clients to save for emergencies or retirement.

NFCC鈥檚 changes, coming later this year or in 2017, make the plans 鈥� especially the savings component 鈥� much more attractive. Having money set aside to deal with emergencies can make it easier for people to stay on the plans. Plus, emerging debt-free but without an emergency cushion may put many people back in the same situation that got them into trouble in the first place.

Yet there鈥檚 one change needed that isn鈥檛 coming: Borrowers need to be told that bankruptcy could be a faster, cheaper solution.

A typical debt management plan requires people to repay thousands of dollars over time. The average debt level of the people who participated in 2013 was nearly $20,000,聽, another large nonprofit. In addition, the counselors levy an average fee of $24 a month, according to the NFCC, or $1,440 over five years.

By contrast, a Chapter 7 liquidation, which erases credit card debt and most other consumer debt, typically takes four months and costs roughly $1,500, depending on the area. Bankruptcy stops collection actions such as lawsuits and wage garnishments, and battered credit scores typically rise after a filing. Bankruptcy also gives people a fresh start.

Federal law requires people who file for bankruptcy to consult with a credit counselor. But people who sign up with credit counselors aren鈥檛 required to talk to a bankruptcy attorney. While potential NFCC clients may be told bankruptcy is an option, counselors aren鈥檛 lawyers and can鈥檛 give legal advice, Keating says.

That鈥檚 not enough, says attorney Ed Boltz, president of Washington, D.C.-based聽.

Credit counselors 鈥渟hould say, 鈥榊ou should consult with a lawyer before you sign up with us,鈥欌�� Boltz says. 鈥淥therwise, you could be making some big mistakes.鈥�

Borrowers also need to know that dropping out of a plan can have serious consequences. Creditors can resume collection efforts, and borrowers also have flushed thousands of dollars down the drain and might not have enough money left to seek legal help or file for bankruptcy.

So, those thinking about a debt management plan should make an appointment with an experienced bankruptcy attorney first. (Consultations are usually free.) That way, they will be able to understand the choice they make.

Liz Weston is a columnist at NerdWallet, a personal finance website, and author of 鈥淵our Credit Score.鈥� Email:聽lweston@nerdwallet.com. Twitter:聽.

This article was written by and was originally published by The Associated Press.