Not all debts are the same. Although most forms of lending carry risk, certain lending decisions are more likely to send you into a downward debt spiral. We call them debt traps.
It's incredibly easy to fall into the debt trap. All that is needed is a short lapse in judgment. One example is opening a new credit card account without understanding the interest rates and fees or the implications for your credit score.
No one wants to go into debt, especially when common borrowing mistakes are preventable. Read on to discover the seven biggest debt traps and ways to avoid them.
Buy Many Houses
In general, you shouldn't spend more than 28% of your gross income on living expenses and the total debt-to-income ratio (including car payments, credit card bills, student loans, etc.). While these numbers aren't definitive, especially if you live in a high-cost area, they provide a good framework for calculating how much home value you can afford.
Next, calculate the maximum advance payment you can make. Try putting 20% down on your new home to avoid paying private mortgage insurance. You should also consider closing costs, which typically range from 3% to 5% of the property price. So if you want a new home listed at $200,000, you'll need to budget at least $48,000 to cover the 20% down payment plus 4% closing costs. It's also important to consider property insurance and taxes, which can significantly alter your debt-to-income ratio. You'll probably also want some money for emergencies, and it's always a good idea to put some money aside for emergencies. If you're not financially there already, keep saving. It's best to buy a house only when you can afford it. Buy one when you can't, and a foreclosure is a real possibility.
Co-signing a loan
To attach your name to someone else's debt is like taking on the debt yourself. If the borrower does not follow through in payment, it's up to you to foot the bill. And if late fees accrue or there is a default on the loan, your credit rating could be affected, and you could even wind up in court.
Worse, if you suddenly need extra money, you may be denied a loan simply because your lenders think you already have too much debt because of the co-signed loan. The only sure way to avoid this debt trap is to simply say no when asked to c0-sign a loan.
If you choose to take out a loan together, make sure that, in the worst-case scenario, you can repay the debt to avoid a lower credit score or legal action. You can often negotiate the terms of your obligation with a lender, asking you to limit your liability only to the loan itself and not to overdue receipts, legal fees, etc. You can also ask the creditor to let you know if the debtor misses a payment.
Prowling your 401(k)
It can be tempting to borrow from 401(k). The loans are tax-free, and the fees are often much lower than those on a credit card. The problem is that you seem to borrow from a good lender – yourself. Despite the superficial appeal, many risks are associated with temporarily withdrawing 401(k) money, even if the money is yours.
If you quit your job before repaying the loan, prepare for a drastic decrease in your retirement savings. Debtors generally have 60 days to repay the full balance. Otherwise, the loan will be considered a distribution, resulting in tax penalties and early withdrawals depending on your age.
The biggest hit may come from the loss of growth potential. If funds are missing from 401(k), they cannot grow in your future. Because many plans let you borrow up to $50,000 over five years, that's a lot of lost growth potential.
Only borrow from the 401(k) if it is an emergency and you have had access to all other sources. If you go ahead with a loan, it is recommended that you take out as little as possible and maintain an aggressive repayment schedule. Also, try to keep making regular contributions, at least enough to earn your company match, and most importantly, don't take out a loan if you're thinking of quitting your job or worried about being laid off.
Mismanaging Credit Cards
One wrong turn on the credit road can haunt you for a long time. Start with a late payment, which can lead to a higher APR (annual percentage rate). If your payment is delayed for more than 30 days, it will affect your credit score. Once your credit score takes a hit, so does your potential future loan.
As your balance increases each month, it becomes more difficult for you to pay your bills, dramatically increasing the time it takes to pay off your debts. Additionally, a damaged credit rating makes it difficult to get new lines of credit, which may require you to charge more to your current card or receive a cash advance.
Using more available credit can further damage your credit score, especially if you exceed 30% of your revolving credit limit. This cash advance also comes at a steep price: interest begins to accrue from the day you withdraw the money. You are now more in debt, have destroyed your credit score, and have fewer loan options.
Don't give in to these common credit card mistakes. Send in more than the monthly minimum, pay your bills on time, monitor your credit score, and keep an eye on your spending habits.
Binging on Student Loans
The most important lesson you need to learn when deciding how much student debt you owe is not to overestimate your ability to pay. The old school of thought used to be not to borrow over the course of four years what it takes to pay for one year of college. However, with skyrocketing tuition, financial advisers encourage students to match education costs with future income expectations.
Check the pay scale in the dream field. If you want to become a social worker, taking on $150,000 in student debt might not make sense. Instead, explore more affordable educational options.
Borrowers need to see the big picture. For example, if you need $5,000 to cover fees each semester, keep in mind that in four years, that seemingly small amount will be $40,000. Higher education is another important aspect. If a master's or doctorate is in the future, it may be worth looking for cheaper colleagues. Finally, exhaust all federal lending options before turning to private lenders.
Summary
Avoid high-interest loans, such as payday, car, mortgages, on-call, and tax-payable loans.
Credit cards can be very useful but should be used with caution. The best way to avoid debt pitfalls is to carefully read the terms and contract and pay your bills on time.
Mortgage refinancing doesn't make sense for everyone.
Overdraft protection programs can also be helpful, but they are never free and can give you even more debt. Again, read your agreement carefully, and be sure to pay the amount in your overdraft account immediately to minimize your charges.
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