What is credit counselling and how does it work?

Wikipedia defines credit counselling as “a process that is used to help individual debtors with debt settlement through education, budgeting and the use of a variety of tools with the goal to reduce and ultimately eliminate debt.”

In some countries it is a mandatory process before anyone can file for bankruptcy. Different countries have different regulation for it. Credit counselling agencies can be not-for-profit, no fees entities or they can also be for-profit, charging very high fees.

How credit counselling works?

The credit counselling works on a three step approach.

First Step : Evaluate the current credit health status

Second Step : Draw a personalized plan on resolution and to increase credit score

Third Step : Implement the plan and evaluate on a regular basis

The first task of any credit counselor is to understand the individual financial situation. It is thus important that the debtor should not hide any fact from counselor. Most debtors come with multiple loan defaults, very low credit scores and no income source to payback the loans. In such a distress it is counselor's job to first give confidence to the debtor and understand the complete picture.

Next the counselor tries to chalk out a plan for repayment, settlement and negotiations. A debtor may here authorize the counselor to negotiate with creditors on his/her behalf. Counselor then tries to discuss debtor’s situation with lenders and tries to get the best possible solution, whether it is a waiver of interest amount (partial or full), an extension for payment duration or settlement through partial payment.

During this time, the counselor also educates the debtor about the various rules, regulations and personal finance management techniques through which the debtor can plan for payments as negotiated and avoid getting into similar situation again.

Finally the counselor may also suggest a debt management plan (DMP) to the debtor. Herein, the debtor legally hands over his/her financial liabilities to the counselling agency and makes monthly payments to them, which the agency then re-distributes among lenders as per negotiated terms. It is important to note that while DMP may seem like an easy solution, it costs money and involves sharing your sensitive personal information with the counselling agency.

Does credit counselling affect credit score?

A counselling session by itself will never affect your credit score, but if you take a DMP, it may affect your credit score negatively in the short run. Because, first, it usually involves paying off debt accounts and closing them one after another. Second, a loan settlement or partial payment will again negatively affect your credit report. Lastly, if the agency stops making payments on your behalf it will further damage your credit history. But a debtor who needs DMP may already have a bad credit score due to bad financial history and hence in the long run it only helps close all bad debts and start afresh.

Things to be careful about

It is important to take credit counselling if you are in deep debt and don’t have sufficient resources to close the debts. But it is also important that you select your credit counselling agency carefully. Always select a reputed and authorized agency and beware of those who upfront ask for large fees or sensitive personal information.