Debt Traps: How to Avoid Debt by Being Careful (2024)

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10 Debt Traps & Tips: How to Avoid Debt by Being Careful

There are lots of products and services on the market that may promise temporary relief from your debt—and some of them can. But most of them are just debt traps that can make your financial woes even worse. Here are the10 Debt Traps and tips on how to avoid them.

Debt Trap #1: Credit Cards

Credit cards are a double-edged sword. In other words, they can be very helpful when you needcash, 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 exorbitant:

• Late payment fees – If your payment is even one day late, you may be subject to a late fee of $39 or more.
• Over-the-limit fees – If you go over your credit limit by even one dollar, you may be subject to a fee of $35 or more.
• Cash advance fees – Most companies charge from 2%-4% of the amount advanced, with no maximum amount.
• Balance transfer fees – Some creditors charge as much as 5% when you transfer the balance from another card. That’s a $150 fee on a $3,000 transfer. So if your intention is to lower your interest rate, you may not achieve your goal when you consider the fee involved.
• Annual fees –Some cards have annual fees as much as $400. That’s a lot to pay for the convenience of using a credit card, especially when there are plentiful 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 if you have been delinquent on any other credit accounts! They regularly monitor your credit report, and if you’ve been late on any accounts, they’ll penalize you.
  • “Rewards” programs. Any reward program that you have to pay for isn’t reallya reward program. If it’s free—take it! If not—stay away!
  • Credit card registration services. These services compile all of your credit and debitcard account information and arrange for the cancellation and replacement of anylost or stolen cards. Yes, it’s convenient. But it comes with a price tag of anywherefrom $49 to $99 a year, and you can do what they do all by yourself in about 20minutes—for free!

TIPS: Read all credit card agreements thoroughly; and make all payments on time, or even a few days early. Useful resources are the Pay Off Credit Card, Credit Card Optimizer and Personal Financecalculators. If you find you are just treading water on your credit cards, try credit consolidation.

Debt Trap #2: Overdraft Protection/Bounce Protection

Overdraft protection and “bounce protection” provides for the payment of your checks—up to a specific amount—if you don’t have enough funds in the bank at the time. You can also tap into it using an ATM if you’re strapped for cash. But it’s far from free:

• The overdraft fee for a bounced check or over-limit withdrawal can be over$35 per incident, regardless of the amount.
• Most programs demand that all fees, and the overdraft amount, be repaid within 30days. But some demand repayment in 16 or even five days; and if you don’t pay ontime, they can send the account into collection!
• Some banks even charge a daily fee of as much as $ 10 until you have repaid theoverdraft amount.

TIP: If you’d like to sign up for an overdraft protection program, make sure you are aware of the terms you are agreeing to. Know what your fees are, when they are triggered, and whether or not your overdraft protection amount is included in your daily balance. Understand that “Overdraft Protection” is an optional feature of a bank account and that you can opt out of it.

Debt Trap #3: Mortgage Refinancing

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 tosign up for another 30 years of mortgage payments?
• 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.
• Finally, stop thinking of your house as an ATM machine. The purpose of a 30-year mortgage is to have it paid off when you retire, to reduce your expenses when your income decreases. Borrowing from your home will keep you house poor.

Debt Trap #4: Payday Loans

These loans are basically very expensive credit. You write a personal check to a lender for, say, $120, in order to borrow $100 for two weeks. The lender holds your check until your next payday, at which point the lender deposits your check, or you pay another fee to extend the loan another two weeks. So if you roll the loan over three times, that’s 3 x $20, and you’ve paid $60 to borrow $100! That’s an annual percentage rate of 521%!

Payday Loans are likely 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.

Debt Trap #5: Car Title Loans

Title loans are secured by the title for your car, and the lender decides how much it will loan you for your car, as well as the time period of the loan. Not only can the annual interest on these loans be as much as 264%, but you may also lose your car if you’re even one day late on your payment!

TIP: If you must resort to a car title loan, make sure you read your agreement thoroughly and you are certain that you will be able to pay on time.

Debt Trap #6: Pawnshop Loans

Pawnshop loans 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 of yours(collateral).
• You only get half of the item’s resale value.
• Interest can range from 2% to 25% per month, and the loan period can range from 30to 60 days.
• If you don’t repay by the agreed date, your property will be sold.

Debt Trap #7: Home Equity Loans

Warning! These loans can be dangerous to your financial health:

• They are secured loans that use your home as collateral. They may provide somemeasure of immediate financial relief, BUT if you miss any payments, you couldactually lose your home. In fact, some unscrupulous lenders are counting on youmissing 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 iteven worse because it gives you access to more money.

Debt Trap #8: Rent-to-own

These companies allow you to buy appliances, furniture, and even computers, through a weekly rental payment plan. The two major problems are:

• When you add up the weekly payments, you will always be paying several times morethan the fairmarket value of whatever you’re renting!
• If you miss a payment, the store will take the merchandise back, no matter how muchyou’ve alreadypaidfor it.

In the age of Ebay and Craigslist, 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 #9: Credit Repair

Noone needs to pay anyone to “repair” his or her 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 writingletters detailing whateverit is you are contesting.
• The easiest way to improve your score is to pay all of your bills on time and pay atleast the minimum.
• You cannot erase negative information on a credit report if it is true.
• 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 $79-$129 a month that a credit repair program charges 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 healthy credit behavior.

Debt Trap #10: Income Tax Refund Loans

These are short-term, secured loans from tax-preparation services. The security they use is the income tax amount you expect from the government.

• They carry outrageous interest rates and fees, ranging anywhere from 67% to 774%!For example, a$500 loan of this kind can cost $197 in fees and interest.

Let’s Recap…

In this article,we’ve discussed debt traps: Products and services 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 toavoid debt traps is toknow exactly what your terms are by reading your agreementthoroughly, and to pay your bills on time.
• Overdraft protection programs can be helpful as well; but they arenever free, and they can send you furtherintodebt. Again, read your agreement thoroughly and make sureyou repay your overdraft amountimmediately to minimize fees.
• Mortgage refinancing doesn’t make sense for everyone. Use an online calculatorto determine if it makessense for you.
• Steer clear from high-interest loans such as payday loans, car title loans, pawnshoploans, renting-to-own,and income tax refund loans.
• No one needs to pay to repair his or her credit. You can correct errors on your creditreport and improveyour credit score all by yourself, with a little time and effort.