Americans’ total credit card debt passed the $1 trillion mark for the first time in the third quarter of 2019. To put that number in perspective, that’s the equivalent of 1 million millionaires.
And credit card debt only accounts for a little over 25 percent of the total debt. Not all of that debt is bad but a good chunk of it is due to some common debt traps.
Let’s look at some of the most common debt traps people fall into and why you need to avoid them.
The Dangers of Credit Cards
Credit cards are the most dangerous trap for most people. Once you get into the credit debt cycle trap, it gets harder and harder to dig yourself out.
Credit cards make it easy to buy things we can’t afford. Just charge it on your card and make small payments every month until it’s paid off.
It sounds good but making those small payments means you’ll be in debt for years. And if you keep spending more money on credit, the cycle gets worse.
Add the interest, late payment fees, cash advance fees, and all the other charges the credit card companies ding you with and you’ll never see the end of that debt.
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Overdraft Protection and NSF Fees
Overdraft protection can be a useful tool if you use it wisely. If you write a cheque or an automatic payment goes through when you don’t have enough money in the bank, it can save you the hassle of sorting out a missed payment (not to mention the late payment fees).
The problems come when you use overdraft protection as a form of credit. Similar to credit cards, once you start relying on your overdraft, it will get harder and harder to wipe out that debt.
Plus, many banks charge fees for going into overdraft or for insufficient funds. Those fees send you deeper into the hole.
Refinancing Your Mortgage
Refinancing your mortgage seems like a reasonable way to pay off debt. After all, credit cards and other types of consumer debt typically have much higher interest rates.
By refinancing your mortgage to pay off other types of debt or to avoid having to take it on in the first place, you’ll save quite a bit of interest.
The problem is your mortgage is what’s known as secured debt. Your home becomes security for the mortgage loan. If you can’t pay the mortgage for some reason, you could end up losing your home to foreclosure.
Credit cards and many other types of consumer debt are unsecured. While the lender can take you to court to try and recover the money they’re owed, they can’t foreclose on your house to get it.
Changes in Property Value Can Cause Problems
Another potential risk with refinancing your mortgage is that you could end up overextended if property values drop suddenly. You could end up owing more on your mortgage than your home is worth if you sold it.
This is a big part of what led to the housing crisis in 2008. When the bottom dropped out of the housing market, thousands of families were left holding mortgages for more than the value of their homes.
Payday loans are another type of debt trap to avoid at all costs. These are short-term loans that use your paycheck as security against the loan.
Payday loan companies typically charge a fee to borrow the money. For example, you might have to pay them $120 to borrow $100, with the $20 difference being the loan fee.
Whether you call it a fee or interest, the end result is the same. If you calculate the annual interest rate based on the fee you pay, you’ll often find payday loans resulting in 500 percent (or higher) interest annually.
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Draining Your Savings to Pay Off Debt
On the surface, it seems like using your savings to pay off debt is a good decision. Paying off the debt sooner means you’ll pay less interest and that difference can be significant over time.
The trouble with using your savings to pay down debt is that it leaves you with no emergency funds. If some kind of emergency pops up such as a health problem, car trouble, or unexpected home repairs, you won’t have the cash on hand to deal with it.
You might have the credit available to pay for it but that puts you right back where you started.
And if that credit is no longer available once you paid off the debt, you could end up with no reasonable way to pay for what needs to be done.
It’s a good idea to hold onto some of your savings in case one of those situations comes up.
Living Beyond Your Means
Most of these debt traps come down to the same bottom line — you’re living beyond your means. If you’re paying for things on credit cards, borrowing money to pay for other things, and relying on debt to maintain your lifestyle, you’re setting yourself up for a rude awakening.
These traps tend to snowball as time goes on. The credit card balances grow, mortgages get refinanced for larger and larger amounts, and your monthly income gets stretched thin.
Left unchecked, these debt traps will spiral out of control until it all comes crashing down around you. At that point, you could face foreclosure, bankruptcy, and various other consequences.
Learn How to Come Out of These Debt Traps Before It’s Too Late
Recognizing these debt traps before you get caught up in them will help you avoid a lot of stress and financial trouble. Credit card companies, banks, and other lenders will try to convince you it’s okay to finance your lifestyle with debt but don’t take the bait.
Was this post on ditching debt traps helpful? Be sure to check out the other articles in our Finance section for more practical tips for making your money go farther and avoiding debts.