How to spot, and ditch, bad credit counselors

Hand erasing the word debt on blackboard

You saw them advertised on TV at 3 a.m. during a sleepless night worrying about your bills.

Now you're paying sky-high fees and wondering whether this is really the best way to get out of debt.

Whether they call themselves credit-counseling, debt-settlement or debt-consolidation companies, they are everywhere, and they don't always have your best interests in mind.

Here's a good rule of thumb: The worse they are, the more they advertise.

Credit-counseling, debt-consolidation and debt-settlement services all work a little differently, but they're similar enough that you'll find some firms offering all three services.

Here's how they work:

While there are some good players out there (don't even bother with debt consolidation), the unscrupulous ones charge enormous amounts for their services and don't always do what they say.

"Our industry is no different from any other -- it's plagued with bad actors," says Gail Cunningham, senior director of public relations for the National Foundation for Credit Counseling, a nonprofit organization. An agency is unscrupulous, she says, if it's "more concerned with their bottom line than yours."

Here are some warning signs:

Red flag 1. They push a debt-management plan on you.

Good credit counselors review your finances before offering a solution. They know many consumers can control debt by cutting back on spending, managing their cash more wisely or taking on a part-time job.

Bad counselors will immediately recommend a debt-management plan. That requires you to send large sums of money to the credit counselor, who then doles it out to your creditors.

Bad credit counselors only want to work with you if you'll agree to a debt management plan, or DMP as it's sometimes called, because they want to take lots of fees out of the money you send them every month.

If you decide to go with a DMP, only do so after your counselor has thoroughly reviewed your finances.

Red flag 2. They charge ridiculous fees.

Bad counselors typically charge customers a percentage of the debt they get written off or a percentage of the client's total debt, with no caps or limits on how much that can be. For example, they'll keep $20 out of every $100 you send them.

Good counselors, on the other hand, usually charge a flat fee of $5 to $30 a month to administer a DMP, no matter how much you owe. Those that do use a sliding scale keep something like $5 of every $100 clients send them and cap those fees at $40 per month. But most good credit-counseling firms, if they're nonprofits, will waive the fee if you claim a hardship.

Bad debt settlers will ask for a hefty up-front fee.

Nonprofit debt settlement companies will generally ask for no more than $75 up front. For-profit settlement firms can't ask for a dime until after they do their negotiations, thanks to new rules the Federal Trade Commission instituted in 2010.

For-profit debt settlers can require you to put a fee in a dedicated account, administered by a third party, which they then can draw from if they get a creditor to reduce what you owe. You're allowed to withdraw funds at any time without penalty.

Many law firms are taking up debt-settlement cases, and attorneys are allowed to take up-front fees. Some law firms have made headlines for abusing that privilege. Unless you know these attorneys personally, best to stay away.

Red flag 3. They're not paying your bills.

If they're not paying your bills on time, they're fraudulent.

There is no reason a company offering you a loan should tell you not to pay your bills, and so if they do, that's a major warning, But many debt-settlement companies, even the ethical ones, counsel clients to put money into an account to use as a bargaining chip in getting the creditor to settle for a lower lump sum.

Regardless, you risk being sued if you aren't paying your bills, so you may see it as a red flag even if you're dealing with a reputable debt-settlement firm. Credit-counseling companies should pay the debts you owe, provided you're sending them money every month.

In fact, most credit counselors who create a DMP will have your bills sent directly to their office.

Don't blindly accept monthly statements created by the credit counselor as proof they're taking your money and paying your bills. Go online and look at your credit card statements to confirm that the payments are being made.

Red flag 4. They require a minimum amount of debt.

You should be concerned if the TV ads say, "If you have at least $5,000 in debt, call us," or you receive a telephone solicitation that promises, "We can help if you owe $10,000 or more."

A legitimate agency will be willing to work with you regardless of what you owe. The bad players can't make enough money off customers who only owe a few thousand dollars.

Red flag 5. You're offered a debt-consolidation loan.

It sounds great in practice -- pay off all those nerve-wracking debts and just have one payment -- and some companies that offer credit counseling and debt settlement also have debt-consolidation programs. But good loans are hard to come by.

Unless you have good credit, don't even bother looking for one of these. You won't find a good one.

If you manage to find a good loan, it will have a low interest rate, low enough that when you tally up how long it'll take to pay it off, you'll pay less than it would have taken to pay off the current debts.

Bad loans look good, but mathematically they're devastating. You may pay less per month but over a longer period of time, meaning you could pay thousands of dollars more than you would have if you had stuck with the original debt.

And if you're asked to pay any fee to get a debt-consolidation loan, or if a company wants you to open a line of credit or a second mortgage to pay off your debts, you should ask your state's attorney general to check out your new friends.

If you've already fallen in with the wrong folks, here's how to extract yourself:

Smart move 1. Cut off fraudulent counselors immediately.

If they haven't paid your creditors, or haven't paid them the full amount they said they would, stop paying them. They've broken their agreement with you.

Then report them to your state's attorney general.

Smart move 2. For everyone else, follow the termination process in your contract.

As you might expect, bad counselors charge cancellation fees if you terminate the service.

Know what they are and be prepared to challenge any attempt to charge more.

Send written notification by certified mail of your intent to cancel. That will ensure that the agency receives it, and they won't be able to claim they didn't.

Call your creditors and have your bills routed back to your address.

Smart move 3. Sign up with a good counselor.

We recommend Cunningham's group, the National Foundation for Credit Counseling.

Its 120 member agencies abide by a set of professional and ethical standards that have served many individuals and families well over the past 50 years.

Here's where to find a credit counselor in your area. Click on "Find a Counselor" and follow the prompts to get a list of nearby agencies.