Look Out for That Lifeline

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The programs typically require financially strapped consumers to pay fees up front, so they make money whether or not any useful services are performed," says Philip Lehman, an assistant attorney general in North Carolina.

Although some consumers have found relief with debt-settlement firms, the programs do not have the same success rate as credit-counseling agencies. Credit counselors, which have long-standing relationships with issuers, work with lenders to lower interest rates and create a monthly payment plan for borrowers. According to the National Foundation for Credit Counseling, which represents 1,500 counselors in the U.S., 60% of clients complete the plans.

By comparison, North Carolina prosecutor Lehman estimates that 80% of consumers drop out of debt-settlement programs within the first year. And the Federal Trade Commission, which has settled six cases against settlement outfits in the past four years, found that at one of those firms, just 1.4% of the consumers who entered the program finished it and settled with lenders.

Why? One reason is that some banks, including Bank of America (BAC) and Discover Financial Services, (DFS) refuse to negotiate with settlement firms. The programs, issuers say, only add to their pile of bad debt since consumers stop payment. "This is one instance where both creditors and debtors are worse off," says a credit-card executive who declined to be named.

Meanwhile, borrowers rack up late fees, over-limit charges, and other penalties for missed payments. Creditors may also pass the debts to collection agencies or sue for damages in court. Those blemishes inflict long-lasting damage on a credit report. All that can leave borrowers not only with more debt, but even worse, can force them into bankruptcy—exactly the situation many were trying to avoid.

Barbara Bautch knows what it's like to be on that slippery slope. Unable to manage the $12,000 tab on two cards, the part-time health-care aide in Silver Bay, Minn., signed up with settlement firm American Financial Services in 2006, forking over $233 a month to the Bakersfield (Calif.) company. After one of the card companies sued, Bautch learned that AFS hadn't contacted either issuer regarding a settlement deal. Between late charges, penalty interest, and attorneys' fees, her debt now stands at $20,000. AFS did not return calls for comment. Says Bautch: "AFS drove me into bankruptcy, and it was no sweat off its back."