While a loan can do wonders for you, a poorly chosen debt can catch you off guard. Simply put, a Debt Trap is a situation in which debt has become nearly impossible due to high-interest rates, limited financial resources, and multiple loans with multiple EMI payments. However, if you know the dynamics of debt, you can approach it intelligently.
In this blog, we have discussed various steps that can be taken to tackle a Debt Trap intelligently by educating yourself on its dynamics. So, keep reading to learn more about the same.
Understanding Debt Trap
A Debt Trap technically refers to a situation in which you are compelled to take new loans to pay off your debt obligations. Before you know it, you find yourself in a situation where your debt deteriorates and spirals out of control.
Such a circ*mstance frequently occurs when your debt obligations exceed your ability to repay them.
For instance, the interest on the outstanding loan amounts starts to quickly mount up when your income is insufficient to pay off your debt. This forces you to take out new loans to pay off the accrued interest, which puts you in a Debt Cycle.
Differentiating Between Good Debt and Bad Debt
Particulars | Good Debt | Bad Debt |
Meaning | Any debt that could help you increase your net worth or produce future income is generally called Good Debt. Notably, according to some, it frequently has a low-interest rate or Annual Percentage Rate (APR), which is typically less than 6%. | A Bad Debt is a sum of money owed to a creditor that is likely to go unpaid and for which the creditor is unwilling to take action to collect for various reasons, often because the debtor lacks the funds to do so. |
Examples | Home Loan, Student Loan, Business Loan, Affordable Auto Loan, etc. | Credit Cards are used for impulsive purchases; Personal Loans are used to repay another debt; Payday Loans, Expensive Auto Loans, etc. |
Tips To Help You Escape Debt Traps
Now that you understand what a Debt Trap is and what it entails, let us look at some ways you can escape this precarious situation. A Debt Trap is not the end of the world, even though it is a bad situation for anyone.
Here are some ideas you can implement to escape a Debt Trap.
Pay Your Bills on Time Every Time
By paying off your credit card bills and loan EMIs on time and in full, you can avoid falling into a debt trap in the first place.
Paying only the minimum or partial amount due on your credit cards may seem appealing at the time, but if you continue this behaviour for a very long time, you risk falling into a debt trap.
Identify the Problem
Credit cards are not evil, and not all loans are bad. However, some warning signs could mean you are approaching or already in a debt trap. You are probably trapped in debt if you have several credit cards or are about to reach your limit on one or several. A greater risk is missing EMI payments and being charged interest on more significant sums.
When you cannot make regular payments, and it appears unlikely that you will be able to do so soon, it turns into a debt trap. Furthermore, it is a major red flag if the total amount of debt you have borrowed from various sources exceeds your invested corpus, liquid cash, or other savings. Most importantly, it makes up a significant portion of your salary.
It is time to sit up and notice if you can identify with one or more of the abovementioned situations. Then, it is time to move on to the next step once you have admitted that there might be a problem.
Avoid Taking Out Too Many Loans
It would be best not to take on more debt because you already have much of it. Your total EMI and credit card payments should ideally not exceed 40% of your gross income.
If you exceed this cap, your finances will be stressed, and you'll put yourself in a difficult situation if your payment were to be lost for some reason.
You may also want to know Financial Planning for Beginners - 7 Tips for Saving Money.
Carefully Manage & Organize Your Debt
Your debt may be either Short-Term or Long-Term. For example, credit card debt and personal loans fall under the category of Short-Term Debt, while home loans fall under Long-Term Debt.
Once you have broken down your debt by tenure, you can focus on the loans with the highest Interest Rates, Fees, and Penalties. Long-Term loans with lower interest rates include home loans and other types of loans. Compared to credit card loans, which can have annual interest rates as high as 35%–40%.
Credit cards have a lot of hidden fees and monthly interest for not paying the bills, which raises the possibility of abuse. Failure to pay them back on one or a few occasions results in Interest, Penalty Fees, and an increase in the principal borrowed on your credit card. As a result, order your loans according to the interest rates they carry and the length of time they must be repaid.
Plug in the Leaks and Create a Pre-Payment Plan
First, list your expenses if you are having trouble saving money. Then, try to spend less on non-essentials like Entertainment Trips, Movies, Upscale Purchases, etc. Finally, try to devise creative ways to reduce your daily expenses.
For example, you could carpool to work for a while rather than take a cab or eat home-cooked meals more frequently rather than ordering takeout. If you have the time, you might consider taking on side jobs to generate additional income.
Although it may seem like a struggle, keep in mind that it is only a temporary situation, and once your finances are back on track, you will not need to limit yourself.
You can monitor your finances using various clever budgeting tools and apps. The money you save can then be used to pay off your debts. Making a pre-payment kitty would be a better course of action. Say your goal is to pay off your short-term loans within six to twelve months.
You can invest your savings in liquid funds, short-term debt funds, ultra-short-term debt funds, etc., rather than letting them sit idle in a savings account. They guarantee high liquidity and withdrawal flexibility while providing better appreciation than savings accounts.
Have Enough Insurance Coverage
Purchase adequate insurance to safeguard you and your family from unforeseen events. The lower the premiums will be, the earlier you purchase insurance. Then, if you have insurance, you can put all of your savings toward paying off debt without worrying about rising medical expenses.
Request Your Bank to Increase Your Loan Tenure
You can ask your bank to extend the term if you have a home loan. This may increase interest rates, lowering your monthly EMI payments and giving you more time to pay off debt.
You can also try negotiating the interest rate if you have a good working relationship with your bank. Alternatively, consider moving your loan to a bank with a lower interest rate.
Reduce Expenses & Increase Income Avenues
Given the current income level, making room for such expenses in the monthly budget is the only choice if paying dues is difficult.
This can be achieved by finding new income sources that could produce an adequate amount of income while also finding ways to reduce monthly expenses whenever possible. Therefore, making and following a budget will be very beneficial.
Obtain Protection Against Unforeseen Events
An essential tool for protecting yourself from unfavourable events is insurance. For example, it could be a natural disaster or another occurrence, such as losing your job or becoming disabled due to an accident.
Insurance will assist you in meeting your financial obligations in such circ*mstances and prevent you from getting further into debt.
Conclusion
Debt is both profitable and risky. Borrowing with caution can be beneficial. You will be closer to financial freedom if you take out loans for projects that will enhance your assets, skills, and investment portfolio.
A Debt Trap that prevents you from achieving your long-term objective of financial independence is a long list of bills and EMIs that you will not be able to pay off shortly. However, your financial situation may remain stable if you learn to distinguish between what you want and need.
Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.
