3 TYPES OF TOXIC DEBT AND HOW TO AVOID THEM
Just mentioning the word “debt” conjures up a variety of emotions in most of us. When you add the word “toxic” in front of it, we often go into panic mode. Well, to some degree. Having toxic debt is not wise in any respect. However, sometimes we cannot avoid the situation. In this blog, we will discuss 3 variations of toxic debt and how to avoid or eliminate these unhealthy debts and practices.
What is Toxic Debt?
The most obvious answer is high interest revolving credit. This could be in the form of a payday loan, credit card, personal loan, etc.
In these situations, you spend most of your time, money, and effort paying off the interest and little or no money is going to the principle of the loan.
The following sections list some of the obvious toxic debt traps that you should try to avoid.
Payday Loans.
In the decade’s past, we had what was known as “loan sharks”, today they have been replaced by payday loans. Although they are different entities, the process is still the same. They charge you an inflated amount of interest in hopes that you do not repay the principle, but rather, just keep rolling it over for years.
Most loan sharks and payday loan businesses survive on your
interest payments, which are often at the 35% mark or just North of that. It’s not uncommon in unregulated states to have an interest rate of 50% or greater at payday loan companies.
Not all payday loan companies are necessarily bad. Some do have a moral standing and realize that you are just in a tough situation and need some fast cash. True, they too will charge an inflated interest rate. After all, they need to make money to stay in business. It's best to avoid payday loans if at all possible and try other options when you need some cash.
Pawn Shops.
We’ve all seen them in just about every town USA. Many of us have used them on more than one occasion. I have used pawn shops for years as a source to purchase decent products at a reasonable price. Others use them as a quick cash source when running short on funds by pawning something of value.
Pawn shops, in general, are not as detrimental to your credit score as payday loans, but their interest rates can get a little steep if you’re not careful. This can lead you into a spiral of never-ending debt, something you should try to avoid.
Debt-to-Income Ratio.
This form of toxic debt often slips in under the radar but hits you just as hard as the aforementioned scenarios and is in-itself a type of toxic debt. Having a high debt-to-income (DTI) ratio can be detrimental to your finances as-well-as your credit score.
Calculating your DTI ratio is relatively simple, but it only works if you are brutally honest with your numbers. To calculate your DTI, divide your total monthly expenses by your gross monthly income.
Your total expenses should include rent/mortgage, student loan, car loan, utilities, phone service, etc. but will not include your food costs, clothing, entertainment, etc. Your gross monthly income will be your total income before any deductions, such as taxes, 401k, etc.
For example, if your total income is $4,225 per month and your total expenses are $1,820 per month, then you divide your expenses by your income.
1820 / 4225 = .430769… or 43%
If your DTI ratio is greater than 43%, consider paying off, or at least paying down, your credit card balances or any other loans you may have.
As a general rule, you want to keep your DTI ratio at or below 43%. A lower DTI ratio means that you generally pay your debts, which looks good on your credit score and to lenders, and it shows that you are capable of taking on more debt if needed.
Tips to Get Rid of and Avoid Toxic Debt.
It’s obvious that you should avoid toxic debt when possible. Like many situations, that is easier said than done.
In the event that you find yourself running short of cash, you may consider asking friends or family members for some assistance. Other options include taking out a personal loan at your local bank or simply selling some unwanted items online. Maybe it’s time for a yard sale.
Sometimes you need to get creative in ways to come up with the extra cash you need. Don’t be afraid to think outside the box and take on some additional work in the form of a side hustle. Maybe you can tutor someone on a subject that you know a great deal about. Perhaps you could take on mowing your neighbor’s yards or other such tasks.
If you need more information about different small side hustles to stash away some extra cash, try reading The Penny Hoarder on a regular basis. They have a plethora of ideas and they have maintained an online presence since 2010. It’s not often you see a website that’s been around for more than a decade and still going strong, so they must be doing something right.
A good suggestion would be to find one or more side hustles that won’t overwhelm you and stash that money away to help you avoid falling into the toxic debt trap in the future.
Final Thoughts:
It’s important to understand that not all debt is bad or toxic. On the contrary, there is such a thing as good debt. For example, a low-interest mortgage, student loans, car loans, etc. can be used to your advantage and help build your credit worthiness. Provided that you keep up with your payments, of course. Applying for a variety of credit cards can also boost your credit score and provide that additional cash when you need it the most. Just make sure to use the card(s) with the lowest interest rate.
Perhaps the best advice is to save something back from every paycheck, even if it’s only twenty dollars a payday. In time, it will add up and be that nest-egg that will save you from obtaining toxic debt in the future.
Disclaimer: The information posted on blogs and vlogs by City National Bank is for educational and entertainment purposes only and is not intended as a substitute for professional or legal advice. City National Bank will not be held liable for any loss or damage of any kind in connection with this blog.
