While the very act of borrowing money can be a risky business in and of itself, not all debt is created equal. Certain credit decisions – which we call debt traps – are more likely to lead to a downward spiral of indebtedness than others. The good news is that most borrowing mistakes are preventable, and having an understanding of them will help you get closer to living debt-free. Here are seven of the most common debt traps people fall into – and how to avoid them.
- Overspending on a new home. Most financial advisers suggest spending less than 30 percent of your gross income on housing expenses. When buying a new home, putting 20 percent down is a good way to avoid paying private mortgage insurance (PMI). And dont forget to factor in closing fees, real estate taxes, homeowners insurance, and the cost of decorating and remodeling. If you dont think you can cover these expenses, keep saving. Youll avoid running the risk of foreclosure.
- Co-signing a loan. Attaching your name to someone elses debt is tantamount to taking on the debt yourself. If the borrower doesnt make his or her payments on time, its your responsibility to foot the bill. And if late fees pile up or theres a default on the loan, your credit rating could be damaged – and you might even wind up in court. So even if its for your own flesh and blood, avoid co-signing a loan unless absolutely necessary to prevent paying off debt that isnt yours.
- Borrowing from your 401(k). If youre looking for ways to borrow money, it can be tempting to tap your 401(k). Loans are tax-exempt, and rates are typically much lower than those on credit cards. But it can all go wrong if, for example, you leave your job before paying back the loan. Borrowers are typically given 60 days to repay the balance in full. Failure to do so will deem the loan a distribution, which can generate a tax bill and early-withdrawal penalties (depending on your age). Even if you dont leave your job, depleting your 401(k) can result in a serious blow to your funds growth potential – not to mention your future financial security.
- Abusing your credit cards. Not reducing credit card debt can be a slippery slope. For starters, a single late payment can result in a higher annual percentage rate (APR). If the payment is more than 30 days late, it will likely damage your credit score, too. Once your score takes a hit, so does your future borrowing potential. As your balance swells each month, it becomes harder for you to pay your bills. A low credit score makes it difficult to secure new lines of credit, which could force you to charge more on your current card or, even worse, take out a cash advance. Thats why its so important to not only ensure that you are paying off your credit cards on time, but to pay more than the monthly minimum.
- Binging on student loans. When deciding how much student debt to accrue, assess your personal finance situation to avoid overestimating your ability to pay it back. Take a close look at the salary range in the field you want to enter, and plan accordingly. If you want to become a social worker, for example, it might not make sense to take on $150,000 in student loans. Instead, try exploring more affordable education options. Study at an in-state school rather than one thats out of state, or opt for a community college over a four-year university.
- Over-improving your home. Remodeling your home can be a smart move, but it can quickly turn into a money pit if you choose projects that require considerable investment but promise little in return. Before you commit to a contractor, its a good idea to research the resale value of various home improvement options. If you do choose to remodel, avoid overly personal or over-the-top design choices – most people in the real estate market gravitate to neutrals. Finally, remember to keep your location in mind. You might not recover what you put into your home if your neighborhood leaves something to be desired.
- Starting a marriage in debt. While it may be tempting to spend more than you can afford on your big day, remember that a wedding is just the beginning. If youre like most couples, it wont be long before you start yearning for a house and kids. But if youre too busy paying off wedding bills, it can be difficult to set aside money for financing long-term investments like a mortgage, a 529 college savings plan, or your retirement fund. So when deciding what kind of wedding to have, first make a list of other major expenses the two of you will be facing over the next five to 10 years – and cut corners accordingly.