10 Debt Traps & Tips: Avoid the Quick Fixes That Can Trigger a Debt Crisis

Times are tough for plenty of American households. But if you’re among those attempting to find a way out, beware of debt traps.

Your concern, especially if you are among those struggling to keep your debt payments current — or if, according to the Federal Reserve Bank of New York, you’re among the more than one-in-10 who have fallen 90 days behind on your credit card obligations — is how to fix the fix you’re in.

And that’s where debt traps loom.

There are lots of products and services on the market that may promise temporary relief from your debt — and some of them can do just that. Be clear-eyed as you weigh your options because most temporary relief tools are nothing more than financial quicksand, debt traps that can make your financial woes even worse.

Debt traps lure you into “a vicious cycle,” says Bristol, Vt.-based Christine Moriarty, lecturer, author, and founder of MoneyPeace.com. “You pay the minimum, or you get another kind of loan, and another loan after that.”

Moriarty’s advice: “Stop debting. It doesn’t feel good. It’s not easy. But you have to stop. You have to face your demons.”

Begin by avoiding debt traps. Here are the top 10, and how to avoid them.

Debt Trap #1: Credit Cards

Credit cards are a double-edged sword. In other words, they can be very helpful when you need cash, but if you don’t manage your accounts wisely, credit cards can make your financial situation a lot worse. Here’s how:

Fees can be exorbitant:

• Late-payment fees: If your payment is even one day late, you may be subject to a late fee of $39 or more.
• Over-the-limit fees: If you go over your credit limit by even one dollar, you may be subject to a fee of $35 or more.
• Cash advance fees: Most companies charge from 2-4% of the amount advanced, with no maximum amount. And those charges begin the moment you receive your advance.
• Balance transfer fees: Looking for relief via a low-interest balance transfer card? You may be dinged as much as 5% when you transfer the balance from another card. That’s a $150 fee on a $3,000 transfer. So, if your intention is to lower your interest rate, you may not achieve your goal when you weigh the fee involved.
• Annual fees: Some cards, especially rewards cards, pack annual fees as much as $695. That’s a lot to pay for the convenience of using a credit card, especially when the market abounds with cards with no annual fees.

Sudden changes to your credit agreement can be very costly:

• Rate increases for late payments: On some accounts, a late payment of even one day triggers an increase in the interest rate of the account. Some accounts that begin at 9% can rise instantly to as much as 29.99%!
• Default-rate increases: Some creditors will raise your rate if you have been delinquent on any other credit accounts! They regularly monitor your credit report, and if you’ve been late on any accounts, they’ll penalize you.
• “Rewards” programs: Any reward program that you have to pay for isn’t really a reward program.  If it’s free — take it! If not — stay away!
• Credit card registration services: These services compile all of your credit and debit card account information and arrange for the cancellation and replacement of any lost or stolen cards. Yes, it’s convenient. But it comes with a price tag of anywhere from $49 to $99 a year, and you can do what they do by yourself in about 20 minutes — free!

TIPS: Read all credit card agreements thoroughly, and make all payments on time, or even a few days early. Useful resources are the Pay Off Credit Card, Credit Card Optimizer, and Personal Finance calculators. If you find you are just treading water on your credit cards, consider credit consolidation.

Whatever else you do about credit cards, Moriarty advises, work on breaking the cycle that leads you toward more debt.

“Tell yourself, ‘I’m not going to get deeper in debt today,’” she says. “You can’t get out of debt all at once. But you can handle today.”

Debt Trap #2: Overdraft Protection/Bounce Protection

Overdraft protection, or “bounce protection,” provides for the payment of your checks — up to a specific amount — if you don’t have enough funds in the bank at the time. You also can tap into it using an ATM if you’re strapped for cash. But it’s far from free:

• The overdraft fee for a bounced check or over-limit withdrawal can be $35 or more per incident, regardless of the amount.
• Most programs demand all fees, and the overdraft amount, be repaid within 30 days. But some demand repayment in 16 or as few as five days; if you don’t pay on time, they can send the account into collections!
• Some banks even charge a daily fee of as much as $10 until you have repaid the overdraft amount.

TIP: If you’d like to sign up for an overdraft protection program, make sure you are aware of the terms you are agreeing to. Know what your fees are, when they are triggered, and whether your overdraft protection amount is included in your daily balance. Understand that “Overdraft Protection” is an optional feature of a bank account and that you can opt out of it.

Debt Trap #3: Mortgage Refinancing

When rates are low, even simply compared to your other interest rates, it’s tempting to refinance your home. After all, your monthly payments will go down, and you’ll get some extra cash, right?

Not necessarily.

• Only borrowers with the best credit qualify for the lowest rates.
• Even if you qualify for a low rate, there are still costs and other considerations, such as: Do you want to sign up for another 30 (or 15) years of mortgage payments?
• Be wary of origination fees and other costs associated with a refinance. These costs can run between $1,500-$5,000, on average, for a single-family home, adding to what you owe. Before committing, get a detailed breakdown of all the fees and costs you’ll be responsible for at closing.
• Finally, stop thinking of your house as an ATM. One key goal attached to a 30-year mortgage is to have it paid off when you retire, thus reducing your monthly expenses when your income decreases. Borrowing from your home could keep you house poor.

Debt Trap #4: Payday Loans

So-called “payday loans” are, simply, very expensive credit. You write a personal check to a lender for, say, $120, to borrow $100 for two weeks. The lender holds your check until your next payday, at which point the lender deposits your check. Or, if you’re still short, you pay another fee to extend the loan another two weeks. So, if you roll the loan over three times, that’s 3 x $20, and you’ve paid $60 to borrow $100! That’s an annual percentage rate of 521%!

Because their punishing terms can become self-perpetuating, payday loans are potentially the worst debt trap of the bunch. Many roll into a second loan, and then a third. It’s better to pay late or default on other, lower-interest debt than to surrender your future to a payday loan.

A payday loan may look like a reasonable quick fix, especially in an emergency, but here’s Moriarty’s hand in your face saying, “Stop!”

“People like quick fixes,” she says, “but these often got them into this situation in the first place. This comes from lack of planning and failing to live in reality.”

So, deep breaths, everybody. That way we can avoid payday loans and their sinister twin …

Debt Trap #5: Car Title Loans

Title loans are secured by the title for your car. The lender decides how much it will lend you for your car (probably no more than half its value), as well as the time period of the loan. At up to 25% per month, annual percentage rates on car title loans run close to a staggering 300%. Worse, you could lose your car if you’re a single day late on your payment!

TIP: If you must resort to a car title loan, make sure you read your agreement thoroughly and you are certain you will be able to pay on time.

Debt Trap #6: Pawnshop Loans

Pawnshop loans usually are small, short-term loans intended to be quick fixes for those in a financial bind:

• Pawnshop loan terms are one to four months, secured by some piece of your property (collateral).
• Your loan equals about half the item’s resale value.
• Interest can range from 2% to 25% per month, and the loan period can range from 30 to 60 days.
• If you don’t repay by the agreed date, your property will be sold.

Debt Trap #7: Home Equity Loans

Warning! Home equity loans, or the slightly different home equity lines of credit, can be dangerous to your financial health:

• In either a home equity loan or a HELOC, your home is on the hook. It’s the security that makes certain the amount you borrow is repaid in full — either by you, or through the foreclosure on and sale of your house. While you may receive some measure of immediate relief, if you miss any payments, you could lose your home. In fact, some unscrupulous lenders are counting on you missing your payments so they can collect on your most valuable asset!
• Know what you’re getting into. A straight home equity loan issues a lump sum of money based on the value of your home in excess of your mortgage balance. After a 30-to-60-day grace period, you begin making second mortgage payments (principal and interest) on the entire amount.
• A HELOC establishes a time-limited (five to 10 years) checking account you use to borrow against a percentage of your home’s equity. Your payments are based on the outstanding balance. Many HELOC lenders require you to initiate a minimum draw; if you aren’t actively borrowing, lenders also may charge inactivity fees.
• Whether straight home equity or HELOC, make sure you know whether you’re getting a loan with a fixed or variable rate.
• If your financial situation is due to undisciplined overspending, a home equity loan can make it even worse because it provides easy access to more money.

Debt Trap #8: Rent-to-own

You may think you need this couch or that dishwasher right now but hit the pause button on that rent-to-own option. Rent-to-own companies allow you to acquire appliances, furniture, electronics, computers and more, through a weekly or monthly rental payment plan. But they come with at least two major problems:

• When you add up the payments, you always will pay several times more than the fair-market value of whatever you’re renting to own!
• If you miss a payment, the store will take the merchandise back, no matter how much you’ve already paid.

In the age of eBay and Facebook Marketplace, rent-to-own products all can be bought at a fraction of their retail price. If you don’t have the money to buy something outright, consider other options: Like-new used products and open-box items often are available at a fraction of even discounted retail prices.

Debt Trap #9: Credit Repair

No one needs to pay anyone to “repair” his/her credit. No one can do anything for you that you can’t do yourself:

• If there are errors on any of your credit reports (44% of credit checkers find errors), you can correct them by writing letters detailing whatever it is you are contesting.
• The easiest way to improve your score is to pay your bills on time and pay at least the minimum.
• You cannot erase negative information on a credit report if it is true. However, if the dent is old, and they have otherwise been reliable customers, borrowers who ask lenders to remove negative reports often enjoy success.
• The most reliable way to improve your credit score is to make consistent, punctual payments. More than 30 percent of your score is based on your history of on-time payments. If your payment history was spotty in the past, don’t worry. Start making on-time payments now, and you’ll see your score steadily improve.

Take the $79-$129 a month that a credit repair program charges and use it to clean up old debts on your credit report. You’ll get greater results by doing this. Also, educate yourself on how to improve your credit score with healthy credit behavior.

Debt Trap #10: Income Tax Refund Loans

Income tax refund loans are short-term loans from tax-preparation services secured by the borrower’s projected refund amount.

• Such loans pack outrageous interest rates and fees, ranging anywhere from 67% to 774%!  For example, a $500 income tax refund loan can cost $197 in fees and interest.

Let’s recap.

Above, we have discussed debt traps: Products and services available to help individuals experiencing financial problems, but that often make those problems worse:

• Credit cards can be helpful but should be used with caution. The best way to avoid debt traps is to know exactly what your terms are by reading your agreement thoroughly and to pay your bills on time.
• Overdraft protection programs can be helpful as well; but they are never free, and they can send you deeper into Again, read your agreement thoroughly and make sure you repay your overdraft amount immediately to minimize fees.
• Mortgage refinancing doesn’t make sense for everyone. Use an online calculator to determine if it makes sense for you.
• Steer clear of high-interest loans such as payday loans, car title loans, pawnshop loans, renting-to-own, and income tax refund loans.
• No one needs to pay to repair his or her credit. With a little discipline and initiative, you can correct errors on your credit report and improve your credit score by yourself.

Rather than finding yourself waste deep in financial muck that threatens to suck you under, steer clear of debt traps. Instead, consider alternatives such as a debt management plan, and, as Moriarty advises, “address the root causes” that keep you paddling in red ink by getting coaching from a nonprofit credit counseling agency.