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Related topics: debt, debt reduction, credit counseling, debt consolidation, Liz Weston

Ryan and his wife owe $50,000 on their credit cards. They're still making their payments on time, but they aren't making much progress in reducing the debt. Ryan doesn't want to file for bankruptcy or try to negotiate settlements, saying, "I believe in paying what I owe."

"Is there a way to just pay off these balances without accumulating interest?" Ryan asked me recently in an e-mail. "I realize I will have to close these accounts. But if I can just be allowed to pay on the balance without being charged large interest, we will actually be able to get out from under this mess in a few years!!"

Ryan may be a good candidate for a credit counselor's debt-management program, which is meant to help borrowers pay off their credit card debt over several years, often at reduced interest rates.

But credit counseling isn't a good fit for every overwhelmed borrower, and it has a serious image problem. Bad guys overwhelmed the industry in the 1990s, tainting its reputation. In addition, many people still have trouble understanding the differences among various credit-management options, including credit counseling, debt settlement and debt consolidation.

Image: Liz Weston

Liz Weston

In fact, Ryan, in his e-mail, confused credit counseling, which is designed to pay back all of what a borrower owes, with debt settlement, which is designed to negotiate payoffs of 50% or less of what the borrower owes.

Here's when a credit counselor's debt-management plan may help you:

  • Most of your troublesome debt is on credit cards. Debt-management plans typically can't deal directly with overwhelming medical bills, student loans or other debts, although a credit counselor may offer advice about budgeting and money management that could help you cope with these bills.
  • You have, or can develop, the discipline to stick to a fairly strict budget. A debt-management plan requires you to turn over a certain dollar amount each month to the credit counselor, who distributes the money to your creditors, and you usually have to trim your spending fairly deeply to come up with the cash.
  • You're determined to avoid bankruptcy or debt settlement. Credit counseling is designed to help you avoid bankruptcy or debt settlement, but bankruptcy in particular can be a faster way to wipe out your debt and give you a fresh start.
  • You're not already in too deep. The problem with this form of help is that people wait too long to seek aid. If you have enough income to pay the minimums on your bills and a little bit extra, you'll have the best shot at success with credit counseling. Otherwise, bankruptcy or debt settlement may be better options.

The morphing world of credit counseling

For most of credit counseling's history, the industry was dominated by the National Foundation for Credit Counseling, whose nonprofit affiliates -- usually known as Consumer Credit Counseling Services -- offered lower interest rates and payment plans for people who had fallen behind.

A rise in consumer debt in the 1990s helped spawn hundreds of competitors, many with million-dollar advertising budgets, slick Internet come-ons and sound-alike names.

Some did a good job of negotiating repayment plans. Others charged fat upfront fees, paid their executives even fatter salaries and pocketed much of the money that could have gone to pay off creditors. Some targeted people who weren't even late on their payments, but who were simply disgruntled about their interest rates.

The worst were fly-by-night outfits that disappeared with clients' money, destroying their credit scores in the process.

The Federal Trade Commission eventually took action against several big players in the industry, including now-defunct Ameridebt, and the Internal Revenue Service stripped many others of their nonprofit status. Without nonprofit status, the counselors weren't able to collect "fair share" payments, fees from credit card lenders that represented a portion of the repaid debt and that made up a substantial portion of their budgets. Most went out of business.

What to watch out for

That's not to say all the bad guys are gone. Once you decide you want credit counseling, you should investigate the company or service carefully before signing up. Red flags include:

  • Big upfront fees. Legitimate credit counseling agencies typically charge a small set-up fee of $50 or less. If you're paying a lot more, you may be the one who's getting set up, unless you're getting extensive and personal money coaching that could justify the fee.
  • No accreditation. Legitimate counselors are affiliated with the National Foundation for Credit Counseling or the Association of Independent Consumer Credit Counseling Agencies. The U.S. Department of Justice also maintains a list of credit counselors approved to give pre- and post-bankruptcy counseling, which you can find here.
  • Delayed or missing payments. Some companies pocket your first months' payments as a fee, rather than passing the money on to your creditors. Missing payments can hurt your credit rating. Find out how much of each monthly payment is going to your creditors, and when it will be sent to them.
  • Unrealistic promises. If an outfit promises to settle your debts for little or no money, or says its services won't hurt your credit, you're not dealing with a legitimate credit counselor. The real deal is set up to help you pay back what you owe and will acknowledge there may be some effect on your credit.

What counseling can do to your credit

You may have heard that credit counseling will either have no effect on your credit or that it's "worse than bankruptcy." The truth is somewhere in between.

Credit counseling may have some impact on your credit, or it may have none at all. Some lenders may not want to do business with you, but others will.

Contrast that to a bankruptcy, which is the single worst thing you can do to your credit scores, the three-digit numbers used by lenders to help evaluate your creditworthiness. A bankruptcy can stay on your report for up to 10 years and may make getting any kind of credit tough for several years.

Settling debts also can deal a severe blow to your credit if you're cutting deals with your original creditors. (Once the accounts have been transferred to a collection agency, however, settlements typically won't hurt your scores much, if at all; most of the damage to your credit has already been done by the late payments and the fact that the account was transferred to collections.)

What happens to your credit during counseling largely depends on how your lenders report your account to the credit bureaus. Some creditors report customers as delinquent on their bills until they make three consecutive payments of the new minimums negotiated by their credit services.

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Being reported as late or delinquent can certainly hurt your credit scores, but a simple notation about credit counseling probably won't. The credit-score formula used by most lenders, known as FICO, now ignores any reference to credit counseling that may be in your file, said Craig Watts, a spokesman for FICO creator Fair Isaac.

That said, there are still some lenders that refuse to deal with anyone who has enrolled in credit counseling. And if you fell behind on your payments before you entered credit counseling, those late payments will affect your credit scores even after you've paid off your debts.

If you complete your debt-management plan, which typically takes three to five years, the credit-counseling notation is dropped from your credit reports.

As you can see, there are no easy answers for people who get in trouble with credit. If you're there, be sure to evaluate your options carefully, and don't make a bad situation worse.

Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.