Beware These 5 Debt Traps

Getting out of debt is one of the best ways to improve your retirement prospects. Here's how.

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Senior African American couple paying bills
Alamy
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.


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