The 5 Worst Forms of Debt

debt
Photo by Alexander Schimmeck

I suppose you could live your entire life without going into debt, though modern middle-class society in the United States seems to be designed to require at least some debt. Even if young adults can complete their education without taking on student loan debt, just about all new homeowners need a mortgage in order to afford a house. In some cases, debt is just a cost of middle-class living.

Some debt products should just be avoided, however.

1. Payday loans.

To qualify for a payday loan, you would need to prove a history of income. This will provide you a short-term loan, with the balance and fee due within weeks. Those fees could be $15 to $30 for every $100 borrowed, which on a two-week loan could be considered a 390% interest rate. If you aren’t able to pay off the loan when it is due, you can renew it for an additional fee.

Most people who take out payday loans fall into a cycle of debt, renewing their loans or going back to the lender often. It’s rare that someone in a short-term financial fix borrows money at a high rate for a few weeks and pays the loan off in full.

2. Refund anticipation loans.

These were marketed heavily a few years ago, and now that we’re heading into tax season it’s likely we’ll see more ads. Refund anticipation loans are often offered by the same company you might use to help file your taxes. If your income tax return forms show that the government owes you money, for a fee, these companies will be willing to offer you your anticipated cash now.

You can adjust your tax withholding at your job to make sure you’re not due a large refund when you file your taxes. There are few good reasons to keep paying the government more than you need to every week or two when you receive your paycheck. The “forced savings” rationalization is not a good reason.

3. Gambling.

For the sake of your kneecaps, you don’t want to find yourself in debt to a bookie. Movie drama aside, gambling is always a losing endeavor in the long run. It can be an addiction, so seek help if gambling is controlling your life. One problem is sunk costs. Once you start losing, you want to make up for your losses, taking larger risks.

If you’re a stock trader relying on the margin for making purchases, you might as well be gambling.

4. Rent to own.

If you have young children in school beginning to learn to play a musical instrument, you are likely encouraged to rent the instrument from the store. The rental programs are generally designed to either buy the instrument after some time or return the instrument to the store when the student loses interest. This is the best rent-to-own scenario.

Once you start renting electronics and furniture, you will generally get a bad deal. It’s likely you’ll pay much more than the cost of the product by renting, and you will likely be charged a high rate of interest.

5. Debt used to finance a depreciating asset.

One rule of thumb dictates that debt should only be used to pay for an asset that increases in price. For that to make sense, the price of the asset should increase at a rate higher than the rate of interest on the debt. The only problem is that you can’t consistently predict whether the price of an asset will increase.

Cars, unless they are collectible items, would not qualify under this rule. I would argue that if you need a car to earn money, the benefits of its use might outweigh the cost of the loan. And even a reliable used car could cost more than someone on the first day of his first job might be able to afford.

A few years ago, I knew many people who thought that real estate prices could never go down, conveniently excusing the fact they had no equity in their house. Banks were eager to let them buy their houses with hardly any down payment. If they were forced to sell after their house values dropped 20%, they would be in financial distress. And worse, if they were no longer able to afford their mortgage, they might have to foreclose.

What other forms of debt should people avoid?

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