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

Avoiding Debt Traps

A debt trap is a situation where a person ends up in debt and then finds it difficult or impossible to repay the debt. This can lead to a person missing payments and potentially result in a cycle of re-borrowing. This is where someone is unable to afford the scheduled payments on their debt, so they borrow more money to make the payments, which means they’ll owe even more money, which means they’ll need to borrow more, etc.

A debt trap is called a “trap” because it’s so tough to get out of. For this reason, it’s important to be able to recognize a potential debt trap situation and avoid it. It’s much easier to avoid the debt trap than it is to get out once you’re in.

Here are four types of debt traps that you’ll want to look out for.

Payday Loans

Payday loans are a very convenient – and 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 tough to do. If you don’t repay your loan in two weeks, it becomes incredibly costly.

For instance, in Ontario, the maximum that a payday lender can charge is $15 for every $100 borrowed. That’s 15% interest in two weeks, which works out to 390% over a full year! Compare that to a credit card, which might have an annual interest rate of about 20%, and you can see how expensive a payday loan can be.

Many people who take out a payday loan find themselves unable to pay it 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. While the Ontario government does not allow a payday lender to provide another loan unless the original loan has been paid, there are multiple payday lenders out there and thus it is possible to take out loans from multiple lenders, which can lead to serious debt trouble.

Paying Only the Minimum on Your Credit Card

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 for you to pay off your debt, and you’ll continue to accrue interest each month. For instance, if you have a credit card balance of $5000 and your minimum monthly payment is 2% of the balance, it will take you about 22 years to pay off your credit card debt and you’ll pay more than $5000 in interest charges! You’ll end up spending a lot more, and having a lot less money in your bank account, if you only pay the minimum.

Car Title Loans

A car title loan is a short-term loan where you put your vehicle up as collateral to secure the loan. These loans have very high annual interest rates (often similar to the high rates charged on payday loans) and if you are unable to pay back the loan, the lender is legally able to take your vehicle.

Much like with the other loans listed here, the high interest rate makes it very difficult to repay the debt and very expensive as well. A person who takes out an expensive loan can very easily find themselves struggling with high payments down the road.

Student Loans – Without a Plan to Pay Them Back

Borrowing money to pay for an education isn’t necessarily a negative. For a lot of people, getting a student loan is a way to attend a school and receive an education that can greatly enrich the rest of their lives. However, student loans are often for very 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’re borrowing a large amount can still make it tough to pay back the loan.

If you borrow too much to attend a very expensive school, 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 not be making a lot of money, which can make it very 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, 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 borrow money for school with caution.