We all fall victim to unexpected debt traps from time to time. It’s part of how we grow our financial mindset. Maybe you bought a product that ended up being a dud or perhaps you spent too much on your car. Financial literacy is a skill that takes time to master, and it’s okay to make a few mistakes along the way as long as you always get back up and learn what to do better next time.
However, one of the most harmful mistakes is when debt is involved. What are unexpected debt traps? These are any financial option that might look good on the surface. Perhaps it can be good under some circumstances but quickly goes south in the blink of an eye. Maybe they were too good to be true. Either way, it’s easy to get tangled up in these traps and come out on the other end with an unexpected amount of debt.
A startling 50% of Australians today struggle with financial literacy, so arm yourself with knowledge. Here are a few of the most common unexpected debt traps as well as how to avoid getting caught up in them. Hint: you have more options than you think.
Debt Trap 1: Credit Cards
You probably have this debt trap in your wallet right now. Before you throw your credit card in the shredder, realise that they’re the ultimate double-edged sword in the financial world. They can be an excellent tool to build credit responsibly but they need to be managed wisely.
What are the specific debt traps you’ll find tied up with credit cards?
- Balance transfer fees – There’s usually always some kind of fee when you transfer your balance to another bank. This can be as much as 5% depending on the bank, and that really adds up.
- Cash advance fees – If you take a cash advance from your credit card, you’ll have to pay a fee on this as well usually up to 4%.
- Late payment fees – The fees for failing to pay your credit card on time are high, so you’ll need to closely watch your calendar.
- Annual fees – Many cards today offer high annual fees in order to offer “perks” like cash back deals and discounts. These fees can be several hundreds of dollars, and that’s a lot to pay just to use a credit card.
- Interest rates – Last but not least, interest rates can be predatory if you aren’t careful. You’ll need to pay interest on any balance you don’t pay before your account payment date and failing to pay on time will drive this rate even higher.
Ultimately, credit cards are a vital tool for building your credit and that means you shouldn’t use them recklessly. It’s easy to fall into a debt trap when it comes to that little card in your pocket.
Debt Trap 2: Payday Loans
A payday loan is a form of credit you can get in just a few minutes. These work by charging you higher interest than normal to borrow money for a short period of time. For example, you might repay $1,300 in total after borrowing $1,000 for two weeks. If you need to extend the loan for another week, the interest to be repaid will be compounded, increasing the total you pay over three weeks.
These are the most expensive form of credit. Using the example above, that’s an interest rate of 30% right from the start. A reported 1.6 million Australian households have used payday loans since 2016 and this number is only going up. Payday loans are 20 times more likely to be defaulted on than mortgage loans.
What’s the alternative? Most people rely on payday loans when they find themselves unable to pay their bills or for an emergency expense. It’s a much better idea to have an emergency fund ready or to call upon help from friends and family in your time of need.
Debt Trap 3: Rent-to-Buy
Another debt trap is a rent-to-buy (also known as rent-to-own) scheme. In this type of situation, you’ll agree to rent a home for a specific amount of money each month. This is usually higher than local rent prices but a portion of your money will be going towards a downpayment on the home. After a number of years, you’ll eventually have the option to purchase the home you’ve been renting.
On the surface, this might seem like a great idea. With the housing market becoming a challenging place for newcomers to enter, many new buyers are just looking for an easy way to build equity. Unfortunately, rent-to-buy schemes come with a lot of hidden fees. First, you’ll likely need to save at least 3% to go towards your equity.
Beyond these extra fees, you’ll also be paying an inflated price for the house and higher than average rent. There are much more financially-savvy ways to save for your home than entering a rent-to-buy scheme. Instead, focus on saving money by living within your means, and talk to our debt reduction experts about goals to buy a home in the future.
Debt Trap 4: Home Equity Loans
Finally, the last unexpected debt trap is home equity loans. These can be a major danger not only to your financial situation but also to your housing situation. With a home equity loan, you’re essentially borrowing against the value of your house. Any equity you’ve built in your home is eligible to be loaned to you.
That being said, this also means your home becomes the collateral. If you start missing payments, you could lose your home if the arrears remain outstanding. Ultimately, home equity loans are unlikely to be a good way to restore your finances because it only provides you with short term relief.
Avoid These Debt Traps For Good
In a perfect world, we wouldn’t have to be so vigilant about our finances. In reality, we have to be mindful of these unexpected debt traps so we can keep our money safe. It’s always a smart idea to learn more about your finances and debt. Knowledge really is power and the more you know, the better off you’ll be financially.
If you’re struggling with your current financial situation, talk with an expert from Debt Busters on 1300 368 322. We have over a decade of experience helping Aussies get back on their feet no matter their financial situation. The sooner you act, the more options you’ll have.