7 Tips for Avoidable Debt Traps You Should Know
Debt Traps and How to Avoid Them. Debt isn’t all created equal. While all forms of borrowing carry some risk, certain credit decisions are more likely to send you into a debt trap. These are referred to as debt traps.
It’s all too simple to get into a debt trap. It only takes a little lack in judgment. One example is opening a new credit card account without first comprehending the interest rates and fees, as well as the repercussions for your credit score.
Nobody wants to get into debt, especially when common borrowing blunders may be avoided. Continue reading to learn about seven of the most common debt traps and how to avoid them.
1. Buying Too Much House
In general, housing costs should not exceed 28% of your gross income, and your total debt-to-income ratio (which includes auto payments, credit card bills, student loans, and other debts) should not exceed 36% of your gross income. While such figures aren’t fixed in stone, especially if you reside in a high-cost location, they can help you figure out how much house you can afford, according to Adam Granger, a mortgage adviser in Weston, Fla.
Next, determine the greatest down payment you are able to make. To avoid paying private mortgage insurance, try to put down 20% on your new property. You must also account for closing expenses, which normally run from 3% to 5% of the home’s purchase price. So, if you want to buy a $200,000 property, you’ll need at least $48,000 to cover the 20% down payment and 4% in closing expenses.
It’s also vital to factor in homeowner’s insurance and property taxes, which can drastically change your debt-to-income ratio, according to Granger. You’ll definitely need some money for decorating as well, and it’s always a good idea to have some cash on hand in case of an emergency. Continue to save if you aren’t there yet financially. Buying a home should be done only when you can actually afford it. If you can’t afford one, foreclosure is a genuine risk. Read on to learn more about Debt Traps and How to Avoid Them.
2. Co-Signing a Loan
Associating your name with another person’s debt is the same as taking on the debt yourself. If the borrower fails to make payments, you will be responsible for the debt. If late fees accumulate or the loan is defaulted, your credit rating may be harmed, and you may find yourself in court.
Worse, if you suddenly want additional funds, you may be rejected a loan because lenders believe you already have too much debt as a result of the co-signed loan. The only way to avoid falling into this financial trap is to simply refuse to co-sign a loan.
If you do decide to co-sign a loan, make sure that you can afford to repay the amount in the worst-case scenario to avoid a credit rating downgrade or legal action. You can frequently negotiate the terms of your commitment with a lender by requesting that your duty be limited to the loan itself, rather than late fees, attorney fees, and so on. You can also request that a lender notify you if the borrower fails to make a payment.
3. Raiding Your 401(k)
Borrowing from your 401(k) can be enticing (k). Loans are tax-free, and interest rates are often lower than credit card rates. The catch is that you appear to be borrowing from a reputable lender — yourself. Despite the apparent attractiveness, there are numerous hazards associated with temporarily withdrawing funds from your 401(k), even if the funds are yours.
If you quit your employment before repaying the loan, expect a significant drop in your retirement funds. Borrowers usually have 60 days to repay the entire sum. If you don’t, the loan will be considered a distribution, which may result in a tax bill as well as early-withdrawal penalties, depending on your age.
The greatest damage could be the loss of growth potential. They can’t grow for the future as long as the assets aren’t in your 401(k). Because many plans enable you to borrow up to $50,000 for up to five years, that’s a significant amount of potential development.
Only use your 401(k) as a last resort if you’ve exhausted all other options. If you do decide to take out a loan, Jeanne Thompson, a 401(k) executive at Fidelity, advises taking the smallest amount possible and keeping to a strict repayment schedule. Also, make regular payments — at least enough to get the business match — and, most critically, don’t take the loan if you plan to leave your work or are concerned about being laid off. Read on to learn more about Debt Traps and How to Avoid Them.
4. Mismanaging Credit Cards
A single blunder on the credit road can have long-term consequences. Begin with a missed payment, which might lead to a higher annual percentage rate. If you miss a payment by more than 30 days, it will most certainly hurt your credit score. When your credit score drops, so does your ability to borrow in the future.
As your balance grows each month, it becomes more difficult for you to pay your obligations, lengthening the time it takes you to pay off the debt. Furthermore, a poor credit score makes it harder to obtain new credit, forcing you to overspend on your present card or take out a cash advance.
You could hurt your credit score even more by using up more of your available credit, especially if you go above 30% of your revolving credit limit. That cash advance has a hefty price tag: Interest begins to accrue the day you withdraw the funds. Now you’re even deeper in debt, have ruined your credit score, and have fewer borrowing options.
Don’t make these common credit card blunders. Pay your bills on time, send in more than the minimum payment due, monitor your credit score at AnnualCreditReport.com, and keep a tight eye on your spending habits. Read on to learn more about Debt Traps and How to Avoid Them.
5. Binging on Student Loans
The most important thing to remember when considering how much student debt to take on is to not overestimate your ability to repay it. The traditional school of thought was that you should not borrow the amount needed to pay for one year of education over the course of four years. With tuition rising at an alarming rate, financial aid experts like Kevin Fudge of American Student Assistance are advising students to align their school costs to their future earnings expectations.
Examine the salary ranges in your preferred field. It might not make sense to take on $150,000 in student debt if you want to be a social worker. Instead, look into more cost-effective educational possibilities. Instead of attending an out-of-state school, consider a community college rather than a four-year university.
Fudge also advises debtors to consider the big picture. For example, if you require $5,000 every semester to cover fees, keep in mind that over four years, that seemingly tiny sum will add up to $40,000. Another crucial factor to consider is graduate school. If you plan to pursue a master’s or doctorate, it’s worth looking into less-expensive undergraduate universities. Finally, Fudge advises that you exhaust all federal loan possibilities before turning to commercial lenders.
6. Over-improving Your Home
Remodeling your house can be a good investment, but it can rapidly become a financial burden if you choose projects that demand a lot of money but offer little in return. To avoid falling into this financial trap, research the resale value of various home upgrades before hiring a contractor.
Location is important in real estate, as it is in everything else. Consult with local sales agents to determine the resale value of home renovations in your region. Also, see Remodeling magazine’s Cost vs. Value Report, which breaks down project costs by location. In New England, for example, a midrange bathroom makeover costs $17,620 and recoups 61.1 percent of the cost at resale. The comparable project in the West costs roughly $2,000 more but returns 79.6%.
Avoid making design decisions that are too personal or extravagant. The majority of home buyers prefer neutral colors. Also, don’t make the mistake of being the best house on the block. If your neighborhood isn’t up to par with your blinged-out home, you might not be able to recoup your investment.
After that, find out how you’ll fund the endeavor. If you have enough equity built up, low-interest-rate options include a home equity loan, home equity line of credit (HELOC) or even a cash-out refinance. Don’t use your retirement funds to build the master suite of your dreams. Set aside renovation plans until your resources catch up with your inner designer, if your funds aren’t enough and a low-interest loan isn’t available. Read on to learn more about Debt Traps and How to Avoid Them.
7. Starting a Marriage in Debt
Money disputes are a prominent cause of divorce, so newlyweds should try to limit the amount of money issues that occur in the early years of their marriage. While some of them, such as existing vehicle debts or student debt, are unavoidable, splurging on a wedding is a choice — and a terrible one.
The typical wedding in the United States costs $18,859, although there are several ways to keep costs down: Use a friend’s lawn for the ceremony, cut the guest list, skip the bar, or send out wedding invites online. You can also save money by purchasing a less expensive engagement ring and deferring the exotic honeymoon. You can splurge on both in a few years when your financial situation has improved.
When you’re first starting off, it might be difficult to think about the larger picture financially, but a wedding is only the beginning. Many couples may rapidly long for a home and children, but setting away money for a mortgage and a 529 college-savings plan will be difficult if you’re too busy paying off the wedding expenditures. So, before you decide on the type of wedding you want, make a list of all the other important expenses you and your partner will face in the coming year, five years, and even ten years. If you do, you’ll live happily ever after.