Beware These 5 Debt Traps

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By Tom Sightings

I have plenty of experience going into debt. I've spent over half my life paying down a mortgage. I've taken out more than one home equity loan and have made more than my share of car payments. Have I ever been debt-free? Yes, for the first 18 years of my life. But now that I'm approaching retirement, I am nearing that state of equanimity once again. So I know how to get in and also how to get out.

There are plenty of ways to dig yourself deeper into the hole. For most of us, these are the top five debt traps:

1. Stretch out the car loan so your monthly payments are less. If you take out a three-year loan of, say, $20,000 at 1.9 percent interest, your monthly payment will be about $573. But if you go for the four-year loan at 2.9 percent, the monthly payment is only $443. And the five-year loan at 3.9 percent is just $368. However, for that lower monthly bill, you will have paid $2,095 in interest by the end of five years, compared to only $628 for the three-year loan.

2. Pay the minimum balance on your credit card. When the bill arrives in the mail it tells you that you have options. You can pay the full amount -- say it's $1,200 -- or you can send in the minimum of $25. That seems like an easy choice, until you find out the interest rate on your unpaid balance is around 15 percent. If it takes you five years to pay it off the interest will add a whopping $500 to that initial $1,200 charge. And if you ignore the bill until it's past due you might incur an extra penalty of $25 or more. Even worse, if you write one of those checks the credit card company sends you, that cash loan could cost you a usurious 25 percent interest or more.

3. Keep going to school whether you need to or not. Some 70 percent of college students graduate with outstanding loans, with the average debt now around $30,000. Graduate students owe even more, averaging $57,600. Of course, your loan is only too big if you don't have the income to pay it off. So if your degree is in medicine or engineering you're probably going to be OK. But if your advanced degree is in art history or social work, or you're going to school because you don't know what else to do, then you may have a problem. According to the nonprofit organization American Student Assistance, the people who have the most trouble repaying their loans are those still paying in their 30s and those who drop out without earning their degree.

4. It's a home improvement, so you'll get your money back. If you're a fan of the home renovation TV shows you might think the typical home renovation pays for itself and then some. But you'd be wrong. According to Remodeling, a builders' website, a typical kitchen remodel costing $40,000 would increase your resale value by $27,600, for a loss of $12,400. Adding a bathroom or home office? You'll be lucky to get half your cost back when you sell your house. Go ahead and improve your home if you can afford it, but don't kid yourself. Some of that money represents an investment, but you're spending the rest. And if you take out a home equity loan, you're spending even more.

5. It's not really a loan, you're borrowing against yourself. Many companies allow you to borrow from your 401(k) plan. Under certain circumstances you can also take a short-term loan from your IRA. However, the rules are complicated, and if you break a rule the penalties are harsh. You can also withdraw money from your IRA without penalty for certain expenses such as a first-time home purchase or some medical expenses. But you are subject to income tax on the withdrawal, and once you've spent the money you will no longer have it for retirement.

Borrowing money can be useful. But the recent bubble and recession taught us to be careful. In general, it's better to borrow to invest in an education, house or business. Borrowing to consume is much riskier. With all types of borrowing, you need a plan to pay it back.

Tom Sightings is a former publishing executive who was eased into early retirement in his mid-50s. He lives in the New York area and blogs at Sightings at 60, where he covers health, finance, retirement and other concerns of baby boomers who realize that somehow they have grown up.

Beware These 5 Debt Traps

Securing a favorable interest rate is a prime way to maximize savings. On a major loan repayment like a mortgage, a little upfront effort can save you considerable amounts for years to come. To cash in on this frugal hack, you need to get your credit in shape. That means checking your credit history, making payments on time (and in full), and reducing your debt to available credit ratio as much as possible. It means paying down your balances on all your credit card accounts. The higher your credit score, the lower your interest payments and the higher your savings.

Adjust your withholding exemptions so that your payments to Uncle Sam match your actual tax liability, and you won't wind up with a big refund come April. As exciting as it is to get that big check in the mail, that's money you've been loaning to the government for free rather than having it grow in your own savings and investment accounts. As of the start of April this year, the average tax refund was $2,831. That's $235 a months' worth of money that could be working for you.

Just 10 to 20 minutes on the phone with your cable company, cell phone rep, or any other service provider can result in recurring monthly savings through old-fashioned negotiation. If you're not getting anywhere after asking for a lower rate, ask for the cancellation (or retention) department and see what offers start to come in. If you're unable to haggle down to get the savings you want, you can always shop providers to get your service elsewhere -- probably with a new-customer discount rate, too.

While bulk buying can sometimes lead to unnecessary purchases and overspending, it's a great strategy for savings on nonperishable items like paper products, cleaning supplies and alcohol. When you stock up, you save on the unit price and the trips to the store to restock.

Other than the obvious benefits of reduced health care costs over time, exercising and living a healthy, smoke-free lifestyle can provide some more immediate savings on your insurance premiums.

More stuff equals more to maintain, clean and devote time and energy to. From the size of your home to the size of your clothing collection, more "stuff" generates more expenses. Downsize and watch your savings soar.

For each year after full retirement age that you delay taking Social Security benefits, you accumulate a permanent increase in your benefits of 5 to 8 percent until age 70. This one strategy can increase your Social Security retirement income by more than 25 percent. It would take a lot of penny-pinching to add up to that kind of income boost.
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