How to Avoid These 7 Devastating Debt Traps
Written by Christopher Denyer
There are a lot of products on the market that may promise temporary relief from debt – and some of them can. But most of them are just debt traps that can make your financial woes far worse. While most forms of borrowing involve risk, some credit decisions are more likely to lead you into a downward spiral that can be extremely difficult to recover from.
There is a saying, that “what you don’t know can’t hurt you.” Do you believe that? What about “ignorance is bliss”? I think you will agree that what you don’t know can hurt you and ignorance is not bliss. In the financial world, a debt trap could mean financial death. What is a debt trap? A debt trap lures people into debt that is impossible to pay off. Here are 7 debt traps and tips on how to avoid them.
Debt Trap #1: Credit Cards
Credit cards are the most common of debt traps. They can be great when you need quick cash, but if you don’t manage your accounts wisely, credit cards can make your financial situation a lot worse. Here’s how:
Fees can be excessive:
- Late payment fees – If your payment is even one day late, you may be subject to a late fee.
- Over-limit fees – If you go over your credit limit by even one dollar, you may be subject to a fee.
- Cash advance fees – Most companies charge the maximum Interest rate (20-30%) on the amount advanced.
- Balance transfer fees – Some banks charge up to 5% when you transfer the balance from another card. So if your intention is to lower your interest rate, you may not achieve your goal when you consider the fees involved.
- Annual fees: Some cards have annual fees as much as $500 or more. That’s a lot to pay for the convenience of using a credit card, especially when there are plenty of no annual fee cards available.
Sudden changes to your credit agreement can be very costly:
- Rate increases for late payments – On some accounts, a late payment of even one day triggers an increase in the interest rate of the account. Some accounts that begin at 9% can instantly rise to as much as 29.99%!
- Default rate increases – Some creditors will raise your rate on the card anniversary or based on your repayment history!
- “Rewards” programs. Any reward program that you have to pay for isn’t really a reward program. If it’s free – take it! If not – stay away!
- Credit card registration and tracking services. These services compile all of your credit and debit card account information and arrange for the cancellation and replacement of any lost or stolen cards. Yes, it’s convenient. But it comes with a price tag of anywhere from $79 to $199 a year, and you can do what they do all by yourself in a matter of minutes – for free!
TIPS: Read all your credit card terms & conditions thoroughly; and make all payments on time, or preferably in full a few days before the end of the month.
Debt Trap #2: Mortgage Refinance
When rates are low, it’s tempting to refinance your home. After all, your monthly payments will go down, and you’ll get some extra cash, right? Not necessarily.
- Only people with the best credit qualify for the lowest rates.
- Even if you qualify for a low rate, there are still costs and other considerations, such as: Do you want to sign up for another 30 years of mortgage payments? And what other costs come with the new loan? Do you have an offset or redraw account?
- Also, ask for a detailed breakdown of origination fees and other closing costs associated with a re-finance. These costs can run between $1500-$5000, on average, for a single family home, adding to what you owe.
- Check the “comparison rate” – this figure is derived from the amount of the loan, the length of the loan, the repayment frequency, the interest rate, and the fees and charges connected with the loan. It includes all the costs of the loan.
- Have you got enough home equity to avoid paying mortgage insurance? Avoid capitalising the mortgage insurance on the loan and paying interest on this over 30 years. Remember – mortgage insurance is the bank’s insurance policy of you defaulting on the loan. Ideally, don’t pay this at all…
- Look at the total cost of the loan over 30 years. The average $300,000 mortgage paid over 30 years costs between $650-$700,000. That’s assuming you don’t upgrade your home, alter your loan, or refinance over that time.
Stop thinking of your house as an ATM machine. The purpose of a 30-year mortgage is to have it paid off before you retire, to reduce your expenses when your income decreases. Borrowing from your home will keep you poor.
Debt Trap #3: Payday Loans
A relatively small amount of money lent at a high rate of interest on the agreement that it will be repaid when the borrower receives their next wages. These loans are basically very expensive credit. You essentially pay a lender, say, $120, in order to borrow $100 for two weeks. That’s $20, to borrow $100 for 2 weeks. That’s an annual percentage rate of 520%!
Payday loans are probably the worst debt trap of them all. Most of them roll into a second loan, and then a third. It’s better to pay late or default on other, lower-interest debt than to take out a payday loan. You don’t want to find yourself in this situation…
Debt Trap #4: Pawnshop Loans
These are usually small, short-term loans intended to be quick fixes for those in a financial bind:
- Their terms are one to four months, secured by some piece of property (collateral).
- You only get sometimes less than half of the item’s resale value.
- Interest can range from 2% to 25% per month, and the loan period can range from 30 to 60 days.
- If you don’t repay by the agreed date, your property will be sold.
Debt Trap #5: Home Equity Loans
Warning! These loans can be hazardous to your financial health:
- They are secured loans that use your home as collateral. They may provide some measure of immediate financial relief, BUT if you miss any payments, you could actually lose your home. In fact, some unscrupulous lenders are counting on you missing your payments so they can collect on your most valuable asset!
- If your financial situation is due to overspending, a home equity loan can make it even worse because it gives you access to more money which has to be paid back. If you can’t pay your bills now, there’s a fair chance you won’t be able to after taking out a home equity loan!
Debt Trap #6: Rent-to-Own
These companies allow you to buy appliances, furniture, computers, and even smartphones through a weekly rental payment plan. The two major problems are:
- When you add up the weekly payments, you will always be paying far more than the fair market value of whatever you’re renting!
- If you miss a payment, the store will take the goods back, no matter how much you’ve already paid for it.
In the age of eBay and Facebook Marketplace furniture, electronics and appliances can now all be bought at a fraction of their retail price. If you don’t have the money to buy something outright, consider purchasing it used before signing up for rent-to-own.
Debt Trap #7: Credit Repair
No one needs to pay anyone to “repair” their credit. No one can do anything for you that you can’t do yourself:
- If there are errors on any of your credit reports, you can correct them by writing letters detailing whatever it is you are contesting.
- The easiest way to improve your score is to pay all of your bills on time and pay at least the minimum on your credit cards (preferably pay the entire balance each month!).
- You cannot erase negative information on a credit report if it is true. The only way is to contact the lender and arrange to pay the outstanding balance then request they remove the information on your credit report.
- The most reliable way to improve your credit score is to make consistent, on-time payments. More than 30 percent of your score is based on your history of on-time payments. If your payment history was spotty in the past, don’t worry. Start making on-time payments today and you’ll see your score steadily improve.
- Take the outrageous amount that it costs for a credit repair consultant or program and use it to clean up old debts on your credit report. You’ll get greater results by doing this. Also, educate yourself on how to improve your credit score with good credit behaviour.
Let’s Recap…
In this article, we’ve discussed debt traps: Products available to help individuals experiencing financial problems, but that often make those problems worse:
- Credit cards can be very helpful but should be used with caution. The best way to avoid debt traps is to know exactly what your terms & conditions are by reading your agreement thoroughly, and to pay your credit card on time.
- Mortgage refinancing doesn’t make sense for everyone. Use an online calculator to determine if it makes sense for you.
- Steer clear of high-interest loans such as payday loans, pawnshop loans and renting-to-own.
- No one needs to pay to repair his or her credit. You can correct errors on your credit report and improve your credit score all by yourself, with a little time and effort.
About Christopher Denyer
Christopher is an experienced Accountant, Financial Planner, HNW and Debt Specialist. He is a passionate advocate for educating and empowering people who are seeking real financial freedom and certainty in their lives.
To learn more about Christopher and how you can become a master of your finances, click here and send a message of enquiry today.
