What is Debt Trap? How Can I Avoid It?
What is Debt Trap?
The debt trap is a situation where you are forced to over consume loans to repay your existing debts. Over time, you get stuck in a situation where the debt spirals out of control, exceeding your repayment capacity, making you fall into a debt trap.
There are two reliable indicators of a debt trap
EMI-Salary Ratio
For example, if your EMI is ₹10,000 and your take-home salary is ₹20,000, your EMI-salary ratio is 0.5. Experts recommend that this ratio should be below 0.3.
Loan-Asset Ratio
For example, if your loan balance is ₹25 Lakh and your ₹10 Lakh, your loan-asset ratio is 2.5. Experts recommend this ratio to be under 0.5.
If you are not taking any steps to increase your income, reduce your loan amount or grow your assets, you can easily fall into a debt trap.
How Does a Debt Trap Work?
Whenever you borrow a loan from a moneylender, two elements come into force – the first is the principal loan amount (the amount you borrow), and the second is the interest (the amount the lender charges on the principal loan amount).
You can only make progress in repaying the loan when your principal starts reducing. But there’s a hitch here. When you repay the loan every month, you make a payment towards both the principal as well as the interest. This is because most loans have amortising structures. That means your loan is designed to be paid off in a series of fixed payments over a loan tenure, and each payment you make towards your loan applies to both the principal and the interest.
If you can’t afford to make payments, you are most likely to fall into a debt trap.
How?
The principal amount doesn’t get reduced, and the interest keeps on piling, making it almost impossible to pay off your loan.
What Causes Debt Trap?
- It’s very important that you identify the reasons that could cause you to fall into a debt trap. They include
- Your EMIs exceed 50% of your income
- Your fixed expenses are more than 70% of your income
- You have exhausted your credit card limit
- You have too many loans
- You cannot afford to put aside money for savings
- Your loan application is rejected
Your EMIs exceed 50% of your income
With easy finance available, a lot of people have become compulsive spenders. They easily fall prey to discounts, sales, etc. and end up buying things on EMIs. These EMIs on their own may not be a big amount, but when added, they can be a significant amount, leaving less money to spend on other important things.
If you see your total EMI amount exceed 50% of your income, it’s a red flag – you could be on your way to becoming a victim of a debt trap.
Your fixed expenses are more than 70% of your income
EMI is not the only financial obligation; there are other fixed expenses you need to take care of every month. These expenses include rent, school fees, electricity bills, etc. Ideally, your fixed financial obligations-to-income ratio should not be more than 50%; if it exceeds 70% of your income, it’s a warning sign that you are slowly getting caught in a debt trap. Experts insist that you need at least 30% of your income for other expenses and to meet your financial goals.
You have exhausted your credit card limit
It’s so easy to purchase goods by swiping your credit card – buy what you want without worrying about paying for it upfront. But, if you find yourself in a situation where you’ve maxed out your credit card limits, it’s time to take a pause and rethink your financial standing – you could be in a debt trap.
You have too many loans
If you are repaying too many loans at different times of the month, it can be not only exhausting, but also you may be putting yourself at risk of defaulting. Additionally, you may be losing a lot of money by paying interest on so many loans.
You cannot afford to put aside money for savings
If you are not able to save money every month, it could be because of your debt and other fixed expenses. This is yet another sign of getting into a debt trap.
Your loan application is rejected
If your loan application has been rejected, then it’s the ultimate sign that you are in a debt trap. Before approving a loan, banks and financial institutions check your credit report to assess your creditworthiness. If you are knee-deep in debt with no financial capability to pull off another loan, banks will not extend you with more credit. Even if they do, it will be at a much higher interest rate which can push you into the vicious cycle of debt with less or no hope of return.
When does a credit/loan push the borrower into a debt trap?
In a high-risk situation applying for additional credit or loan might create problems or push the borrower into a debt trap.
For example, a baker takes a loan for raw materials for his shop. Due to low demand, the individual struggles to sell the finished items. The shop owner takes another loan to sell new items to recover from the loss and repay the previous loan.
Unfortunately, the person becomes a victim of the same situation and cannot pay back the loan twice. This is called a debt trap: a circle of loans the borrower finds difficult to get out of.
How to Come Out of the Debt Trap
Determine the problem and analyse it
A detailed and meticulous review can provide you with the answer to your existing debt situation.
Here’s what you can do:
- Firstly, you need to acknowledge and admit that you have a debt problem.
- Identify areas that are causing you to fall into a debt trap.
- Create a plan to work on these areas.
- Make a budget and prioritise your needs
Make a budget and prioritise your needs
After a thorough analysis of your debt situation, you may now be able to identify essential, semi-essential and non-essential expenses.
- Create a priority list of all your needs.
- Make debt repayment your first priority, as that can have a positive and long-term effect on your financial situation.
- Refrain from indulging in non-essential or even semi-essential items at least till you are back on track.
Opt for a debt consolidation loan
Instead of repaying different loans at different times in a month, you could consider consolidating your high-interest debt by getting a low-interest personal loan or a debt consolidation loan. After debt consolidation, you just need to worry about making one payment to one lender every month.
By doing so
- You save money on interest,
- You pay your EMIs on time,
- Your debt gets paid off faster, and
- You regain your financial vigour
Automate the payments
Repaying your loan in EMIs is the financial commitment you make with your lender. Automating your payments can ensure that you do not break this promise. The benefits of setting up an ECS mandate with your bank to automate repayments have the following benefits:
- You regularly pay on time.
- Timely payments reduce your debt faster as you save on interest, late fees and penalties.
- Your credit score gets a boost.
Avoid taking on more debt
While you’ve already borrowed to the hilt, avoid borrowing more. Make it a rule to keep your debt to income ratio, not more than 40%. Otherwise, you’ll be straining your finances so much that you’ll be setting yourself up for a financial disaster if you happen to lose your income for whatever reason.
Look for ways to increase your income
One of the ways to get out of debt is to increase your income. The extra income can be used to pay off your debt faster. Pick up freelance gigs or a second (part-time) job that’s relevant to your skills, knowledge and experience.
Pay off the expensive loans first
If you are not considering debt consolidation and want to pay your debts separately (tackling one debt at a time), create a plan to pay off the most expensive loan first.
Check your credit score frequently
A healthy credit score is the hallmark of a good borrower. If you have a score of 750 and above, you attract the best of lenders, best of interest rates and best of loan terms. So, if you want to enjoy a healthy financial future, you need to keep a tab on your credit score. Make it a point to request your credit report at least once in 3 months or after the closure of a loan account. Check whether the details recorded are correct and as per your expectations.
Get professional help
If you find it difficult or almost impossible to get out of the debt trap on your own, it is best to consult an expert. Financial professionals can offer you counselling on your budget and impose spending limits. Some professionals may even negotiate with the lender on your behalf to make the loan terms more favourable for you.
Debt Consolidation – A Clever Solution to Come Out of Your Debt Trap!
Debt consolidation is one of the best ways to make your financial situation healthy. If you carry around multiple high-interest loans or outstanding credit card balances, you are slowly stirring a recipe for a financial mess. Taking a low-interest personal loan is a very clever step to be debt-free. The personal loan helps clear all your outstanding balances and convert your multiple payments into a single monthly payment made towards your debt consolidation personal loan.
Why taking a debt consolidation loan makes sense?
- A debt consolidation loan allows you to lower your interest rate, reduce your monthly payments, and pay off your debt quicker.
- It enhances your financial freedom and helps you to budget your monthly expenses properly.
- Since you need to make just a single monthly payment rather than multiple loan EMIs, you reduce or eliminate the chances of missing payments, thus avoiding late fees and higher interest rates.
- It ensures timely payments that improve your credit score and enhance your creditworthiness for future loans.
