You may have heard about debt settlement as a panacea to your debt problems or an alternative to bankruptcy. Ads usually say something like this: "Settle your debt in less than six months!" or "Reduce your debt by 70%!"

Debt settlement companies promise to trim down your debt by dealing with the creditors, but it is not at all clear about its effect on your credit. If you thinking debt settlement as a possible solution to your debt problems, you need to see the entire picture first.

What do you do?

You call the debt settlement company and detail them your problem. You give them the amount you owe and names of your creditors. The company then shows to you how you can reduce your debt together with a new and lower monthly payment. The settlement company advises you to stop paying the creditors and instead give your payments directly to the settler.

What does the debt settlement company do?

The first one to four payments you send go straight into the settlement company’s pocket. It’s their fee for providing settlement services to you. The remaining payments are put accrued in an account. Once the account has grown to a certain amount, the debt settlement company calls your creditors and begins negotiating a settlement with them.

What are the dangers of settlement?

At the first glance, debt settlement does not look so bad. After all, you pay the settler, who, in turn, pays the creditors without much hassles. In the end, you are able to pay all your debt and can now move on with your life.

But there are hidden costs. And they will haunt you in your sleep. You might be scratching your head, "Why on earth did I stop paying my creditors while a settlement was still being negotiated?" There is a lot of things you should know.

Jim Young, CEO of Accelerated Debt Consolidation, says that creditors can only settle your account after it has been charged-off. Meaning, you have to go six months, at least, without paying credit accounts. He also also says that any forgiven amount more than $600 will be reported to credit bureaus as income and will be taxed by the government.

Another thing you need to know: Delinquent accounts are reported to credit bureaus seven years after the date you first became delinquent. Settling your account restarts the clock, thus lengthening the time that the accounts will be reported and included in your credit score.

Furthermore, even if the settler successfully settles with the creditors, your credit report retains the delinquent information. Your account is instead updated as "Paid-Settled" or "Charged-Off Settled" – definitely not as as good as a "Paid in Full" account.

Are there other settlement alternative?

Debt settlement is certainly not for you if you are current on your accounts and want to keep up a good credit score. You may want to consider consumer credit counseling. As long as your payments continue to be made on time each month, this alternative will not hurt your credit. You can also work out your own payment plan with your creditors. Young suggests that if you have missed one or two payments, ask your creditors if they offer a hardship program.