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.