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Beware of costly debt traps

Borrowing almost always carries a certain risk. But it's important to understand that not all debt is created equal. Any time you make a credit decision you should give it thoughtful and serious consideration. No matter if the amount is large or small, all financial dealings deserve your time and good judgment before you sign on the dotted line.

In the world of credit, certain types of loans can quickly lead to a downward spiral of crushing debt which is very difficult to overcome. These are called "debt traps". Unfortunately, it's very easy to get caught in a debt trap. Consumers who are unaware of the more common types of this debt are more likely to make quick and unwise decisions which can result in severe financial difficulties both in the short and long terms. Opening a new credit card account without fully understanding the interest rates and terms of the contract is just one example of how people get into financial trouble.

Many common borrowing mistakes are avoidable. You simply have to educate yourself. Once you recognize debt traps and understand the financial harm they can cause, you can easily avoid them.

Read on to learn about the most common debt traps. It's good to remember that in all matters financial, "forewarned is forearmed". Find out how to protect your financial future and not be taken advantage of.

Costly Debt Traps and How to Avoid Them

  1. Buying More House Than You Can Afford. You only need to look at what happened to the housing market over the past five years to understand the truth of this statement. The massive amount of foreclosures was mainly due to the fact that people signed on to mortgages which they could not legitimately afford. Financial experts suggest that you not spend more than 28% of your gross income on housing expenses.

    The more money you can apply as a down payment, the better off you will be. 20% of the total purchase price is what most financial planners advise. You must also factor in homeowner's insurance and real estate taxes, which can be considerable amounts. If the numbers don't add up, keep saving. To avoid the possibility of losing your home to foreclosure, it's best to purchase a home only when you can truly afford it.

  2. Misusing Your Credit Cards. It's important to know the right way to use credit cards. Ideally, you should never charge more than you can afford to fully repay at the end of each billing cycle. By doing this, you avoid late fees, overlimit fees and interest charges. However, millions of American consumers continue to use their credit cards as a way to live well beyond their means. If you only pay the minimum amount due each month and continue to make new purchases, it will probably take you at least a decade to fully pay off your outstanding balance.

    One late payment can result in a higher annual percentage rate. If you are more than 30 days late with a payment, the credit card issuer will report this information to the three main credit reporting bureaus. This will most likely damage your credit score. When your credit score drops it greatly affects your ability to get good rates and terms for any future borrowing. This all ends up costing you more money.

    At most, your goal should be to have an outstanding balance which doesn't exceed 30% of your credit limit. To avoid costly penalties when using credit cards always pay your bills on time and pay more than the minimum amount. And, of course, keep a close watch on your spending habits.

  3. Frequent Use of Payday Loans. Payday or Cash Advance loans have become very popular over the past ten years. Much of this is due to the still sluggish economy and to the tightening lending practices being used by traditional financial institutions. Payday lenders do not adhere to these same strict standards.

    A payday loan can be a financial lifeline when an unexpected event happens such as a medical emergency or an unplanned car repair. But these loans are meant to be used as a one-time solution to a one-time monetary problem. The trouble begins when you take out a payday loan, can't repay it when it is due (in two weeks), then roll it over for another two weeks and then another two weeks. The interest rates and fees continue to snowball until you are suddenly looking at a loan which is 4 or 5 times the original amount and the annual interest charges are 500% or more!

    Before committing to a payday-type loan, consider all your options. Ask your employer about taking a cash advance on your salary. Sell items that you don't need for cash. Consider asking a close friend or relative for help. If you still find that you have to take out a payday loan, make certain that you will have the funds to fully repay your loan within the two week time period. Don't get caught in a cycle of debt from which you can't recover.

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