Debt is a scary thing. It's like being in jail: Once you're in, you have to work hard and be on your best behavior before you are free. A debt trap is simply a situation where debt is extremely difficult to repay. In these situations, you could have extremely high interest rates that make it nearly impossible to pay the principal, you may not be able to change your payment plan or there are numerous fees included with your payment.
Here are some of the most common debt traps to avoid:
Payday loans are one of the most obvious debt traps. These are small loans designed to "help you" financially until your next paycheck. Then, once you receive your paycheck, you repay the loan. However, in many situations, because the interest is so high, individuals cannot pay back the loan in full when it is time for repayment. (Another drawback with these loans is that they come with hefty fees attached to them, making them even more costly.) This can put the loan in default, or you need to take out another loan to repay the original one. It soon becomes a never-ending cycle of debt.
It is extremely easy to swipe your credit card and buy anything you desire, even though you don't have any money. According to Creditcards.com, the average household has accumulated $9,600 in credit card debt.
When you only pay the minimum payment on a credit card with an extremely high balance, you are basically paying just the interest. You are making very little progress in paying off the starting balance. The average interest rate on credit cards is approximately 15 percent. In addition, you may have to pay annual fees or late fees on top of that, burying you even further in debt.
Debt settlement can have its benefits. Debt settlement programs involve a company working with your creditors to settle your debt, allowing you to pay less so you can dig yourself out of debt.
While the promise of debt settlement may sound alluring, it can damage your credit score. Bad credit scores can mean high interest rates on items such as a home or car. In addition, you may have to pay large fees for the debt settlement process, hurting you further.
Debt consolidation is a lot like debt settlement. In some cases, this may not be a bad thing. However, you still need to be wary. When you consolidate your debt, you are extending the repayment process. You end up paying more in the long run. In addition, if you don't stay up on your repayments, you may face severe consequences such as higher interest rates or large fees.
Income Tax Refund Loans
A tax refund loan is when you receive a loan based on how much you are expected to receive with your income tax refund. The downside to these loans is you can expect huge interest rates, sometimes more than 60 percent. Plus, you may incur huge fees.
Home Equity Loans
This type of loan is simply setting yourself up for financial ruin. With a home equity loan, you use the equity of your home as collateral. The amount of money you can borrow depends on the value of your property. While this can be a fast way to receive cash, if you miss any payments and don't keep up on the loan, you could quickly lose your home.
Buying Too Large of a Home
When buying a home, you may want the bigger, more beautiful home. However, if you don't have the income to make those payments (and if you were to suddenly lose your income), you could be perilously setting yourself up to lose everything. When determining how much house you can afford, housing expenses should not exceed more than 28 percent of your income. If they do, keep looking. There are lots of good homes that won't eat up your entire monthly income.
While many American households struggle with debt, that doesn't mean that you have to. Being smart with your money and avoiding the debt traps listed above helps position yourself and your family for long-term financial security and happiness.