Personal Finance
If you’ve researched debt relief products, loans for borrowers with poor credit, or credit repair services before, you know that there is an abundance of businesses in the market offering this type of support. While most of these companies genuinely desire to improve their customers’ financial positions, others could be considered money traps. In other words, financial agreements that are easy to get into, and very difficult to get out of.
We’ve written this article to help you identify common financial traps you may come across while searching for new financial products and services. So, without any further ado, let’s examine a few common money traps and cover the reasons they could put your financial well-being in jeopardy.
Payday loans
Payday loans are short-term loans (usually two-week terms) designed for borrowers with poor credit that need cash in a hurry. With average loan amounts ranging from $375–$500, they may not seem too dangerous upon first glance—that’s because you haven’t seen the APR yet.
Before taking a look at the APR, we should mention that 13 states in the US currently prohibit lenders from funding payday loans. This alone is proof that payday loans are inherently damaging to borrowers’ financial health. But in many states where they’re still legal, lots of people still seek them out.
When you obtain a typical two-week payday loan, you can expect to pay a $10–$30 interest charge for every $100 borrowed. These interest charges bring the average APR for payday loans up to an incredible 391%!
Here’s how that compares to the average interest rates of other financial products:
- Credit cards (15%–30%)
- Personal loans (6%–35%)
- HELOCs (6%–11%)
Your $500 loan could now cost you up to $650. With a full repayment required within two weeks. If you had to take a guess, what percentage of borrowers do you think are able to fulfill that obligation?
According to the Consumer Financial Protection Bureau, only 20% of payday loans are paid in full on time. Borrowers who are unable to repay the loan can “rollover” their balance for two more weeks, but not without incurring another hefty interest charge (which brings the APR up to 521%.)
Unfortunately, this cycle tends to continue for most payday loan borrowers. Unable to get out of the agreement and continue to fall further and further into debt.
Payday loans may not be the best solution if you’re looking for quick funds. Not only are they currently prohibited in several states, but it’s also a very expensive way of borrowing money due to the high APR. Payday loans increase your chances of falling into debt. Therefore, moving forward with an alternative option is a better idea.
Car title loans
As the name suggests, car title loans are loans that use the clear title on your vehicle as collateral. Similar to payday loans, car title loans are short-term (15–30 days) and high rate, typically having APR’s in the triple digits. According to the FTC, car title loans are generally for an amount that’s 25%–50% of the value of the car, usually ranging from $100–$5,500.
The primary reason car title loans can be money traps is due to the APR yet again. Right off the bat, lenders charge an average of 25% per month to finance the loan, which can bring the APR up to 300% (at least.) Like payday loans, many borrowers are unable to repay the loan on time and opt to roll their balances over month to month.
If a borrower gets to a point where they’re unable to repay what they owe, the lender could decide to repossess their vehicle.
It’s wise to avoid car title loans for two reasons: not only is it too expensive to borrow money at that high of a rate, but you could also risk losing your access to transportation. Again, if you have access to any other borrowing options, seek those out first—it’s unlikely that a car title loan will improve your personal finances. There is a safer alternative to title loans—vehicle equity loans. Vehicle equity loans may differ from title loans in some ways. For example, a vehicle equity loan may come with lower interest rates and longer repayment terms.
Cash advances
Cash advances are short-term loans taken against the available credit card balance and limit. Your card will also typically have a cash advance limit as well. For example, you may have a $5,000 credit line, but only $1,500 is available for a cash advance.
While the convenience of getting a quick cash loan from the ATM sounds appealing, there are a number of reasons you should avoid cash advances unless absolutely necessary. Here are a few:
Fees, fees, and more fees
When you take out a cash advance, you’ll have to pay a couple of fees. First, you’ll have to pay a cash advance fee, which is usually a minimum flat rate or a percentage of the amount of your advance, whichever is greater. This fee can be anywhere from 2%–5% of your cash advance amount.
You’ll then pay an ATM fee, which usually costs around $2–$5. Both the ATM operator and your credit card company could charge this fee.
Interest accrues immediately
Many credit card issuers offer what’s known as a grace period—a given amount of time between the end of your card’s billing cycle and the date your payment is due. As long as you pay your balance in full by the due date, you won’t be charged any interest on purchases made during this period.
When it comes to cash advances, there’s no grace period and interest starts accruing. This can be particularly damaging to your financial well-being for the reason we’ll cover next.
High interest rates
Not only does the interest on your cash advance start accruing immediately, but the rates are higher than most other financial products. The average interest rate for cash advances is 23.68%, almost 8% higher than the average rate for consumer credit cards. If you ever have to take out a cash advance for any reason, pay the balance off as soon as possible—the longer you take, the more interest you’ll have to pay.
Credit repair services
While the next example we’re going to cover isn’t a money trap per se, it is a costly financial service that could negatively impact your finances and the security of your information. Continue reading to learn more about precautions you should take if you seek assistance from a credit repair service.
If your credit isn’t at its best, you may have run into issues qualifying for credit cards, personal loans, and other financial products. That’s where credit repair services come in. For a fee (or a number of fees), these companies will review your credit report and dispute any negative items with credit bureaus to raise your credit score.
Why could this be a bad idea?
Well, there are a few reasons. To start, anything credit repair companies can do, you can do yourself—without paying a dime. With enough willpower and education, improving your credit on your own is more than possible.
Secondly, there are several non-profit credit counseling agencies that provide one-on-one financial education to people in need. These counselors review your finances and teach you about managing your money, retirement savings and investing, and financial planning to improve your long-term future results with no cost to you. All you have to do is reach out.
Finally, the Federal Trade Commission has stated that many scammers operate in this industry, and careful research must be done to ensure you’re working with a reputable company. If a credit repair business’s claims sound too good to be true, it’s usually because they are.
At the end of the day, it could be less risky to repair your credit on your own or by working with a credit counseling agency. Not only will you learn how to manage your hard-earned money effectively, but you’ll also save money on costly fees.
Want to start improving your credit today? Take a look at our article “6 Tips for Building Credit”.
Credit cards
Credit cards are powerful, convenient tools that can help you build credit and make major purchases with ease. This convenience comes at a cost, though. When managed poorly, credit cards can quickly get you in more debt than you can handle.
To make sure you avoid the money traps that many credit card users fall into, we’re going to share a few tips you should keep in mind when swiping plastic:
- Carefully consider making purchases you can’t afford to pay in cash, especially if they’re inessential
- If you do make a large purchase you can’t afford in cash, a detailed repayment plan is critical
- Do your best to avoid using more than 30% of your credit limit
- Don’t keep a revolving balance on your card just to earn rewards
If you follow these four tips, you’re already better off than a good number of credit card users. To learn more about each of these bullet points in detail, read our article “Best and Worst Ways to Use Credit Cards” for the full scoop.
That’s all we’ve got for now. Hopefully, this article has helped you identify a few products to watch out for and motivated you to take a closer look at the fine print before making financial agreements. By steering clear of these money traps (or at least managing them carefully and responsibly), you can ensure your financial well-being is well protected. Need some help with debt management? Check out the free Debt Manager tool at Best Egg Financial Health.
This article is for educational purposes only and is not intended to provide financial, tax or legal advice. You should consult a professional for specific advice. Best Egg is not responsible for the information contained in third-party sites cited or hyperlinked in this article. Best Egg is not responsible for, and does not provide or endorse third party products, services or other third-party content.