The fund will cancel up to half the debt of individuals who have been unable to make repayments for more than six months, South Korea's Financial Services Commission said in a joint statement with government departments. The debt relief scheme will apply to debts up to 100 million won ($90,000).
The fund was one of President Park Geun-hye's campaign promises. High household debt is blamed for causing a slowdown in consumer spending at a time of weakening economic growth.
Park had promised an 18 trillion ($16 billion) fund but the commission estimated it would need 1.5 trillion won over the next five years. State-owned Korea Asset Management Corp. will oversee and manage the fund.
High household debt in South Korea is legacy of the country's real estate bubble and credit card boom early last decade.
The government-backed debt relief includes giving more time to repay loans, lower interest rates for individuals earning less than 40 million won ($36,000) a year, and postponing repayment of student loans until graduates have a job.
The financial regulator expects about 210,000 South Koreans will benefit from partial debt cancellation and another 340,000 would qualify for a reduction in loan interest from over 20 percent a year to under 10 percent.
Policymakers have been looking for ways to prevent South Koreans on low incomes from defaulting on their debts.
Economists say that easing household debts and boosting domestic consumption are crucial for helping South Korea's export-dependent economy overcome its current slowdown.