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Most people have learned and understand the basics behind building wealth: earn more than you spend, avoid debt, and invest.

However, many people either haven’t been taught or don’t recognize the common debt traps companies employ and once you’ve fallen into a debt trap, you quickly become a slave to the lender.

To help you avoid these common debt traps, I’ve listed them below along with some guidance on how to recognize and avoid them.

Credit Cards

Credit cards are like any other tool. It can be useful and make your life a little easier if used responsibly, but can also be dangerous.

Some of the benefits include:

Earn Cash Back

Earn Perks When Traveling

Build Credit

Earn Promotional Offers

Some of the drawbacks:

Late Payment Fees

Exceeded Limit Fees

Cash Advance Fees

Balance Transfer Fees

Annual Fees

Rates Increases for Late Payments

Default Rate Increases

Exorbitant Interest Rates

Buying with Credit Exclusively to Maximize Rewards, Cash Back, or Savings

No one has ever gotten ahead financially solely on rewards, cash back, or savings on purchases. People who focus on these things often buy more than they need in order to get these benefits and actually spend more over time.

Think about it, would the financial industry really keep these added benefits if they didn’t ultimately make money off of them?

To avoid this, start a budget. Learn how to shop on a budget. Create a list ahead of time. Buy what you need, regardless of the extra perks.

Using Your Savings to Pay Off Debt

This is a case where the analytical answer to the problem isn’t necessarily the right answer. On paper, it makes more sense to pay off high interest debt with low interest savings. However, this doesn’t take into account the risk of not having savings for any emergencies that may arise.

The best course of action when paying off debt is to keep a small emergency fund (enough to handle the more likely emergencies like car or home repairs) to ensure a small financial hiccup doesn’t derail your debt repayment efforts. Not only will this set you back financially, but psychologically it will feel like you’ve lost momentum and may kill your enthusiasm and keep you from devoting the same amount of discipline and effort towards paying off your debt.

Dipping into Your Retirement Account to Pay Off Debt

This is similar to taking money out of savings, plus the added penalty associated with taking your money out early and the taxes associated with your typical 401k, IRA, etc. If you have Roth accounts and are only taking out the principal, you still have the penalty to deal with.

Mortgage Refinancing

Mortgage Refinancing to Get a Better Interest Rate

When mortgage rates are at an all time low (like during the recent recession), mortgage refinancing can be very attractive, and for good reason. If the interest rate is significantly less than your current rate, you could end up saving thousands over the long run.

However, there are some caveats to realizing that lower interest rate and taking full advantage of it:

You’ll need an excellent credit rating to qualify for the lowest interest rates

There are typically fees associated with refinancing that get added on to the loan (typically $1,500 – $5,000 that get added to your loan balance or you’ll be responsible for paying upfront)

Typically, the term of the loan will start back over (i.e. if you had a 15-year loan, the new loan will start over again with 15 years

If you are refinancing to get the better interest rate, calculate how many payments you’ll need to make to recoup the costs of financing. If this is longer than you plan on owning the house, refinancing for the lower interest rate may end up costing you.

Mortgage Refinancing to Cash Out Equity

If you have a significant amount of high interest debt, it can be attractive to perform a cash-out refinance in order to pay off these debts. If at all possible, you should avoid putting yourself in a position where you feel the need to do this. Every time you perform a cash out refinance, you are essentially starting all over with your mortgage.

This is just treating the symptoms that are a result of having debt. To truly get ahead, you need to break the habit of using debt to pay for things you can’t afford.

Payday Loans

Payday loans are some of the worse kind of debt. They prey on people who are ignorant, weak willed, and oftentimes desperate. What they offer is an advance on your paycheck for a fee. Since you’re already struggling, this fee only makes it that much more difficult to get ahead. Because of the initial fee, you find it hard to pay off the payday loan, so you extend the loan another couple of weeks, for another fee. Before long, you owe on the payday loan and can’t afford to pay it either.

The average payday lender charger $15 for every $100 borrowed. That equates to an annual percentage rate (APR) of approximately 400 percent. For comparisons sake, the average credit card has an APR of 15 percent. As you can see, payday loans are some of the most expensive forms of credit you can obtain and you should avoid these loans at all costs.

If you need cash immediately there are other ways to obtain cash. You can sell some belongings, ask for an advance at work, ask family and friends for temporary help, ask your church for help, work overtime, work a second job (depends on how quickly you need the money), etc.

Car Title Loans

Car title loans are another form of predatory lending in that they prey on people that are desperate for quick cash. The terms of a car title loans are often better, but that’s only because you are offering up your car as collateral. If you make one misstep (make a late payment, don’t pay the required amount, etc.), you could easily lose your car for a fraction of what it’s worth.

Again, use other ways to obtain cash if you really need it.

Pawnshop Loans

Another way for desperate people to obtain credit is through pawnshop loans. They are typically short- term loans (1-4 months), can have variable interest rates, and are secured with an item that you offer up for collateral. If you don’t pay back the money according to the terms of the loan, the pawnshop often sells your property and gives you half of the proceeds.

Again, use other ways to obtain cash if you really need it.

Home Equity Loans

If you haven’t figured this out yet, any time you secure a loan with something (car loan, pawnshop loan, etc.), you are asking for trouble. So, why would you do this with your largest asset? Like the loans mentioned above, all it takes is for you to miss a payment or not pay enough, and you can be subject to losing your home.

Do not, I REPEAT DO NOT EVER TAKE OUT A HOME EQUITY LOAN. There are far better ways to secure the funding you need. Also, for most people, a quick infusion of cash isn’t going to solve the inherent issue (which is poor money management); it will only treat the symptoms.

Rent-to-Own

Rent-to-own companies try to attract the unsuspecting customer by offering the ability to rent items, that people otherwise couldn’t afford all at once, for a weekly payment. If you make all of the required payments, you get the privilege of owning the item… for only multiple times what it’s worth!

Even worse, if you miss a payment, they take the item back and any equity you thought you were building in the item is gone.

Do not rent-to-own. You’re much better off working more or saving for the item. These also have the added benefit of building good financial habits in the process.

Credit Repair Services

Credit repair services are a waste of money. They often charge too much to do something you could easily do yourself. For example:

The federal government gives you the ability to check your report from each credit agency (Equifax, Transunion, and Experian) once a year for free. Take advantage of this to check if there are any errors on your report.

If you notice any errors, you can have them corrected by sending a letter to the credit agency detailing what you are contesting.

Pay at least the minimum and pay it on time for all of your sources of debt (credit card, mortgage, loans, etc.)

If you do have negative things on your credit report such as a bankruptcy, the only thing you can do is be responsible with credit and debt moving forward (consistent payments on time and for the right amount, keep your credit card utilization rate low, stay away from new credit, etc.). No matter what you do (or what a credit repair service claims they can do) it will just take time for the ding to your credit to subside.

Whatever you were going to spend on a credit repair agency, instead spend on paying off debt and repairing your credit yourself. If you do that, you’ll make faster progress than you would have hiring a credit repair company.

Income Tax Refund Loans

Yet another way for companies to prey on people who need money fast and who are desperate. These loans, like the other loans mentioned above (payday loans, car title loans, pawnshop loans, etc.) have terrible terms and will only put you further behind on your finances.

These loans are short-term loans that are secured by your anticipated tax refund. They typically have terrible fees and interest rates, all for your tax refund (at least part of it!) a few months earlier.

If you need cash fast, there are much better ways to obtain it. Really if you’re getting a significant tax refund, it probably means you need to adjust your dependents to ensure you’re getting that money throughout the year. Otherwise, Uncle Sam is getting the benefit of using your money throughout the year, interest free!

12 Debt Traps and How to Avoid Them – Conclusion

If you learn nothing else from this article, learn this: these 12 debt traps should be avoided at all costs. They prey on the weak and desperate. Like a drug habit, they get you hooked on using them and before long you’re caught in a debt traps where you feel like you need to use them just to keep up with the payments associated with them.

If you truly need cash quick, there are several alternatives you should try like asking for overtime at work, asking for a cash advance at work, getting a part time job, earn extra money through a side hustle, selling some belongings (not pawning), asking your friends and family for help, asking your church for help, reaching out to a non-profit for help, etc. Don’t be ashamed to ask for help if you need it. You can always pay it forward when you get back on your feet.

Have you fallen for any of these debt traps? How did you get out?

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