Why credit counseling often fails

Could a debt-management plan get your finances back on track? It works for some. But if you're struggling, it shouldn't be the only option you consider.

When people are overwhelmed by debt but don't want to file for bankruptcy, I typically recommend they make two appointments:

  • Another with a bankruptcy attorney.

I make the second suggestion for a number of reasons.

One is that credit counselors and their debt-management plans, which are designed to pay off credit card debt over five years or so, are geared to steer people away from bankruptcy. Consulting with a bankruptcy attorney can help ensure that those struggling with debt know all their options.

The other, even more important reason: I know that even if you desperately want credit counseling to work, it often -- usually, in fact -- won't.

Here are the statistics, straight from the NFCC. Of the 3.2 million people who contacted NFCC agencies for help last year:

  • About one-third were too far gone for debt management plans to help, with too little income, too much debt or the wrong kinds of debt (medical bills instead of credit cards, for example). These folks were advised to seek other remedies -- typically bankruptcy protection.
  • Another third were referred to social-services agencies because of other, underlying issues, such as a gambling problem, alcoholism or other addiction.
  • The final third enrolled in debt-management programs (DMPs), but the dropout rate averages at least 45%.

NFCC spokeswoman Gail Cunningham said 55% of those in DMPs either complete their payments or contact their agency at some point to say they're able to resume payments on their own. Cunningham said she couldn't give me a breakdown of that 55%, so we don't know precisely how many people actually follow through in paying off their bills.

But with the statistics at hand, we know that -- at best -- fewer than 20% of people who contact NFCC for help are any kind of a success story.

When budget and reality collide

I don't bring this up to discourage anyone from contacting a legitimate credit counselor. Some people do complete their plans, and many others get much-needed advice on budgeting, credit improvement and other topics.

Credit counselors also are a key source of housing counseling; HUD-approved housing counselors help ready people to buy their first homes and advise them on navigating the mortgage refinancing and modification maze when their payments aren't affordable.

But I want people to know that if they're counting on credit counseling as a way to avoid bankruptcy, the deck might be stacked against them. They need to consider all their options before signing up for a debt-management plan or any other debt solution.

Roni, who lives near Seattle, wishes she had.

She signed up with a credit counselor and started shoveling money toward her credit card bills. Then collectors started calling about other debts she owed, and Roni realized she couldn't keep up.

"At the time, the (credit) counselor made the comment that she wondered how long it would be before I filed for (bankruptcy) protection because my debt payment was such a large percentage of my income," Roni said. "I was young and didn't know all of my options and would have saved myself a lot of time and stress if I had filed Chapter 13 sooner."

Chapter 13 bankruptcy protected Roni from creditors' calls while putting her on a five-year repayment plan, after which her remaining debt would be erased.

On a budget and on the edge

Of course, I have to note that Chapter 13 bankruptcy doesn't have a whopping success rate either. Fewer than 40% of Chapter 13 filers examined in a 2007 study actually completed repayment plans. Some were converted into Chapter 7 filings, which allowed the debtors to erase most of their unsecured debt, while others were simply dismissed, leaving borrowers once again vulnerable to collectors.

Many Chapter 13 filings fail because the debtors are trying to stop a home foreclosure but don't have enough income to pay off their back mortgage payments even after a plan is in place, said Richard Marshack, a bankruptcy attorney in Irvine, Calif.

Others simply can't live within the budget guidelines required in their repayment plans.

"Debtors must abide by a budget that is set by the Bankruptcy Code," Marshack said. "Most debtors simply cannot live under such a strict budget."

The budget issue is even more acute with credit counselors' debt-management plans, said Steve Rhode, who once ran a credit counseling agency and who now runs GetOutofDebt.org, a Web site that offers free debt advice.

Rhode believes credit card companies that participate in DMPs are more interested in maximizing their returns than in ensuring debtors have sustainable budgets.

"It's calculated all backward," Rhode said. "A DMP is not calculated based on what is reasonable, affordable or sustainable for consumers. It's based on what the creditor wants."

This often leaves borrowers on budgets so tight, Rhode said, that any slight setback -- an unexpected bill, a drop in hours at work -- throws them off track.

"People will agree to anything when a DMP is put in front of them, because they think it's going to help," he said, "but it's going to fail the next time they hit a bump."

The NFCC recently persuaded major credit card issuers to accept somewhat lower payments and budgets that include a savings component, so debtors can try to insulate themselves from such bumps. But Rhode isn't impressed. The savings component is good, he said, "but where the hell has that been all these years?"

Know your options

If you're struggling with debt, here's my advice:
  • Do it yourself, if you can. If you can trim your expenses and pay more than your minimum balances, you're typically better off tackling your debt yourself. List your credit card debts by interest rate and throw as much money as you can at your highest-rate balance while paying the minimums on the rest. Once that debt is paid, aim the same payment at your next-highest-rate debt and continue on until you're debt-free. If your credit is good, you might also consider using peer-to-peer lending services such as Lending Club or Prosper to "refinance" your debt at lower rates.
  • Heed the warning signs. Many people -- most, in fact -- seek debt help too late. They ignore the red flags warning of potential financial disaster. Some of these include struggling to make your minimum payments, borrowing from one card to pay another and tapping your retirement accounts to pay your debts. If any of these happens, you're in over your head and should consider getting help.