Are you considering opening up a credit card, financing a new car, or taking out a short-term loan?
While loans, financing, and lines of credit can be beneficial tools, debt can also be a double-edged sword that can leave you financially trapped for far longer than you initially plan.
Below, I’ll share some cautionary tips to help you avoid falling into a debt trap.
Debt: easy to get into and hard to get out of
If you’re a younger individual and just starting to build your credit and financial history, the temptation to get into bad debt may be high.
As soon as you come of age, credit card companies will start sending you offers to open an account, retail stores will entice you to open up lines of credit, and buy-now-pay-later programs will tempt you to make purchases far higher than your budget allows.
If you don’t have a solid financial plan, it can be easy to say ‘yes’ to every offer only to find yourself swept up in a wave of debt that will leave you struggling to stay financially afloat for months or years at a time.
Good debt vs. bad debt
Not all debt is bad. Credit cards, when used responsibly, can be great tools to help you build your credit score and can help you earn cash back. A solid business plan backed by a business loan could be the key to making your entrepreneurial dreams come true. Applying for a low-interest home loan can help you avoid the ever-increasing cost of rent.
All these forms of ‘good’ debt tend to be well-planned and responsibly accounted for. ‘Bad’ debt, on the other hand, tends to be driven more by impulse and desperation. Some examples of bad debt could include:
- Financing a car payment that’s above what your budget allows
- Using a retail credit card to go on a shopping spree
- Getting a high-interest, short-term loan to fund a vacation
- Opening up multiple credit cards and spending without a plan to pay them off by the end of the billing period
Tips to avoid falling into bad debt
With all of that in mind, here are some straightforward tips that can help you responsibly build credit while avoiding debt traps.
1. Understand how credit card interest works
When you open a new credit card, you may be given an initial interest-free period, where you won’t be charged any interest on your card’s balance. All you have to do is make your minimum monthly payment on the card. This can encourage irresponsible overspending during the first year of owning the card.
Once that brief promotional period is up, though, credit cards can charge exorbitantly high interest rates (often as high as 30 per cent APR or more) on any balance that you roll over into the next billing period.
This is why it’s important to only use your credit card as you would your debit card. Personally, I recommend using your credit card to pay for daily pre-budgeted expenses like groceries or fuel.
Then, make sure that you pay your credit card off before the end of the billing period. This will allow you to avoid interest charges on the card, while also taking advantage of any cash-back deals offered by the card. Since you’re making all of your payments on time, this will also help you build and maintain a good credit score.
2. Avoid using buy-now-pay-later programs
Buy-now-pay-later programs can be helpful if used for certain essentials that you may not be able to afford upfront. For example, if you need to purchase a computer for school or purchase a uniform for work.
However, you shouldn’t use them for regular retail shopping. This can easily get you in over your head in debt, as you’ll be required to make weekly or bi-weekly payments toward your balance.
3. Make a higher down payment if you finance a car
For many, financing a car is unavoidable. While you could buy a cheap ‘beater’ car for cash, these cars often come with so many repair costs that they’ll end up costing more in the long run and leave you without reliable transportation for weeks on end.
That being said, if you do finance your car, I recommend making a higher down payment. This will reduce the principal balance you owe and give you a more affordable monthly payment.
Another tip here: you’ll often get a better interest rate if you can get your bank or credit union to finance the car rather than a dealership. Dealerships often act as middlemen and may profit by tacking on extra interest to your loan.
4. Avoid payday loans like the plague
Payday loans are short-term loans that are offered based on the assumption of your next paycheque coming in. They’re often given to individuals with lower credit scores and come with high interest rates and fees.
Although payday loan companies are regulated by the Financial Consumer Agency to prevent “predatory lending,” payday loans should still be avoided, as the high interest and fees make them far more expensive than a traditional loan from a bank.
Try to live below your means
One of the best ways to avoid falling into a debt trap is to live below your means. I’ve seen many people fall into a debt trap due to living above their means, stuck in a paycheque-to-paycheque lifestyle. Unavoidably, an unexpected expense or financial curve ball comes along, forcing them to take on debt or lines of credit just to pay the bills.
The best way to ensure that you’re living below your means (or at least within your means), is to create a budget and stick to it. While some may look at a budget as a limitation, I prefer to see it as a tool for building financial freedom and a stress-free life that will allow you to spend your money guilt-free, since you’ll know exactly what you can afford.
Christopher Liew is a CFA Charterholder and former financial advisor. He writes personal finance tips for thousands of daily Canadian readers at Blueprint Financial.