What are "Debt Traps" and How Can You Avoid Them?

A debt trap is when someone takes on more debt (borrows more money) for the express reason of paying down their existing debts. The “trap” typically happens when your debt obligations exceed your ability/capacity to pay them. You end up chasing the existing debt with new debt and it becomes a vicious cycle. Before you know it, you are caught up in a situation where the amount of debt that you owe becomes uncontrollable, no matter what you do.

We label these scenarios the debt “trap” because they are so tough to escape from. For this reason, it is important to be able to recognize a potential debt trap to avoid it. Here are four common examples of these traps you will want to look out for and avoid:

Payday loans are the ultimate debt trap. They are a very convenient – but an incredibly expensive – way to borrow money. The concept of a payday loan is that it is supposed to help you “until payday.” Most payday lenders expect their loans to be repaid in two weeks. However, in practice, this is often impossible to accomplish, hence the “trap” effect. Most payday loan users are not able to repay their loans within the two-week timeline – that’s when things start to become incredibly costly.

For instance, in Ontario, the maximum that a payday lender can charge you is $15 for every $100 borrowed. That is 15% interest in two weeks, which works out to (are you sitting down?) a whopping 390% over one full year! Compare that to a credit card, which might have an annual interest rate of about 20% (still high but more manageable), and you can see how expensive a payday loan can truly be.

Many people who take out payday loans find themselves unable to pay the loan back on time, which means they might end up taking out another loan from another lender, and potentially another loan after that, to make ends meet. In these situations, the costs add up very quickly. I have seen clients in our practice who have 10 or 12 payday loans running concurrently, all at different lenders. It often becomes a full-time job just to keep track of, and pay down, each loan bi-weekly!

The minimum payment on a credit card is the smallest amount you can pay each month without being charged any late fees or potentially going into default. The way the minimum payment is calculated will depend on the credit card company.

Paying only the minimum will keep you out of trouble with the lender, but it will also mean that it could take years (or even decades) for you to pay off your debt, and the outstanding balance will continue to accrue interest each month. For instance, if you have a credit card balance of $5000 and your minimum monthly payment is 20% of the balance, it will take you about 22 years to pay off your credit card debt and you will pay more than $5000 in interest charges (effectively double the original debt borrowed from the lender). You will end up spending a lot more on debt recovery and have a lot less money in your bank account, if you only pay the minimum.

A car title loan is a short-term loan where you put your already paid-off vehicle up as collateral to secure the loan. Normally the vehicle needs to be a maximum of six years old to qualify for the loan. These loans have extremely high annual interest rates (often like the high rates charged on payday loans) and frequently have a large administrative fee tacked on to the front end. If you are unable to pay back the loan, the lender is legally able to seize your vehicle and sell it to recoup the loan.

Much like the other loans listed here, the high interest rate on a car title loan makes it exceedingly difficult to repay the debt and awfully expensive as well. A person who takes out such a loan can very easily find themselves struggling with high payments for an extended period or, in worst-case scenario, end up losing their vehicle to the lender.

Borrowing money to pay for your education is not necessarily a negative. For a lot of people, getting a student loan is a way to attend a desired school and receive an education that can enrich them long term. However, student loans are often for large amounts of money. While the interest rates on these loans may not be as high as some of the other loans mentioned here, the fact that you are borrowing a large amount can still make it tough to pay down the loan.

If you borrow too much to attend a school offering an expensive program, or if you borrow without having a plan for repaying your debt, you could find yourself struggling with student loan debt after you graduate.

When you first graduate from school, you may need time to find employment or may be working at a lower income rate then you originally hoped, which can make it exceedingly difficult to repay what you owe. A lot of people who have large student loans find themselves turning to other types of loans (credit card, lines of credit, pay day loans, etc.) to make ends meet.

Your student loan payments could make it difficult to achieve many of your life goals unless you have a plan to repay them. Plus, you can only include student loan debt in a bankruptcy or consumer proposal if you have been out of school completely for at least seven years — so please borrow money for your schooling with great caution.

If your debt has become a major problem, and you think you need some assistance getting it under control, please reach out to our licensed professionals today by clicking on the FREE CONSULTATION button, below, or giving us a call. We are here to listen – and to help you!