The accumulation of debt has always been a source of resentment. However, there may be situations where one has no choice but to take on debt. This can include getting a home loan, education loan, or personal loan to manage unforeseen events or health emergencies.
Whatever the situation, it is best to avoid taking multiple lines of credit. If this happens, one must ensure that he/she can repay these loans on time. Not overusing credit limits is vital to ensuring that we don’t fall into the debt trap.
What is the debt trap?
A debt trap is a situation in which a borrower is forced to take out new loans just to pay off existing ones. In essence, a debt trap occurs when debt obligations exceed an individual’s ability to repay loans. Loans are repaid in two components—the principal and the interest amount—over a predetermined period.
The debt trap may not necessarily be caused solely by expensive or expensive loans. If the borrower’s income is sufficient, then a large loan can be repaid without hassles. Therefore, the loan amount cannot necessarily be offset by the debt trap.
However, if EMIs are not paid on time, interest on the amount owed will continue to increase and may include late payment penalties. This keeps the overall debt of the individual inflated.
In such a scenario, the borrower may end up taking out a new loan to pay off the previous one. A small loan may also push the borrower into a debt trap if he cannot pay it off on time and the interest component continues to increase each month.
There are other reasons why one might unintentionally fall into debt. For example, a person may have taken out an expensive short-term loan to overcome an immediate crisis. Or perhaps one borrowed a small amount but suddenly lost the ability to repay due to job loss.
Sometimes, a borrower may put off a total debt repayment, hoping to do so once they receive the payments owed to them and they have more money available. However, if their plans do not materialize, they will end up defaulting on their loan obligations.
Avoiding the debt trap is imperative because it has multiple ramifications. Other than financial and credit outcomes, it can lead to serious psychological and social problems. Therefore, proper money management and timely repayment are crucial to ensure that one does not fall into a cycle of debt.
Differentiate between good debt and bad debt
It is necessary to differentiate between good debt and bad debt. Yes, religion can be good, too, although this may seem surprising. To understand this, debt must be separated into two types: income-generating and non-income-producing.
Debt incurred to purchase an asset that helps in generating revenue for a long time is classified as good debt. On the contrary, a loan/debt which is purchased against a non-revenue asset can be considered as bad debt. Of course, strictly speaking, the term “bad debt” refers to a loan that cannot be recovered and must be written off.
Avoid and manage debt
Getting out of any debt trap can be stressful and stressful. To avoid falling into the debt trap, it is crucial to plan for current and future financial needs and then take on debts that the individual can pay off.
For example, paying in part or paying only the minimum amount owed on credit cards may seem like a sound way to keep things going. But if this habit goes on for too long, the borrower may soon find himself trapped in debt because high interest fees keep accumulating.
One critical method of debt management is to analyze the different types of debt incurred. Further, the total holding period, the specific interest rate of each debt and the total amount owed to the individual also need to be scrutinized and he will decide the best way to manage the debt.
Once these aspects are understood, one can prioritize debt. It is then possible to find out which loans will attract more interest and penalties if payment is late and therefore must be paid off first.
Factors that help you avoid debt traps
There are other important factors to simplify the repayment processes and avoid falling into the debt trap. These include:
Create an emergency fund
One of the best ways to avoid falling into the debt trap is to have an emergency fund. This can be done by ensuring that the individual has savings equivalent to 6 months’ salary earmarked for emergencies. This emergency fund can be helpful in avoiding falling into the debt trap.
With an emergency fund, one can get around a temporary crisis like losing a job and keep things running for a few months until the situation stabilizes.
Consolidation of different loans under one loan
Serving multiple loans with different interest rates can be challenging and stressful. This problem can be solved by taking out one loan, for example, a personal loan, to repay other loans and thus merging all debt obligations into one loan. This can simplify the life of the borrower and help him get out of the debt trap.
To be clear, it is possible that some older loans are offered at higher interest rates. But you can approach a bank or other lender and seek a new loan at a low interest rate to consolidate all your previous loans under the new loan. This can significantly reduce EMI outflows.
Even if the repayment period goes up somewhat, it will still be comfortable enough to manage cash flow and prevent falling into the debt trap. Also, you no longer need to worry about remembering multiple payment dates. Debt issued in one day helps in better managing monthly expenses.
Checking monthly expenses
Sometimes, we tend to splurge without checking spending patterns or expense heads. By keeping track of monthly expenses and budgeting them, one can identify and prevent wasted expenses.
This helps eliminate unwanted expenses and reduce discretionary spending to focus on the essentials. A disciplined approach to monthly spending habits can reduce the risk of falling into a debt trap.
Monthly Debt Service Balance
One good way to protect yourself from falling into the debt trap is to make sure that your total EMI does not exceed 40% of your net monthly income. In the case of a home loan, this percentage can be as high as 50%. For this, one must consider net income after tax, provident fund (PF) and other expenses.
The point above is important because debt traps usually occur when an individual’s monthly income is insufficient to service normal loan obligations.
Track the market value of your home equity
This is vital to avoid negative equity to your net worth. For decades in India, housing prices have generally only moved in an upward direction. But over the past decade, real estate prices have fallen or stagnated in most geographies.
With this in mind, it is essential to keep track of your home ownership, which is the current market value of the property, minus any mortgage or mortgage attached to the property or the principal amount owed.
The amount of equity in a home (or its value), fluctuates over time as additional payments are made on the mortgaged property while at the same time market conditions affect its current value.
Under normal circumstances, while one continues to pay off the home loan over the years, its value continues to rise and the ownership of your home always remains positive. However, when real estate prices drop, your home ownership turns negative. This can put you in some trouble because the bank or lender may ask you to provide more margins to make up for the decline in the property value. Keeping track of your home balance will ensure that you are not financially surprised.
Increase cash flow to prepay high-cost debt
This is a simple way to get around the debt trap. When there is a temporary influx of money such as capital gains from stock sales, an annual bonus or the sale of ancestral property, use this to prepay high-cost debts such as personal loans, credit cards, or auto loans.
When the higher interest rate loans are paid off, you are actually saving the extra amount that would have been for the higher interest fee.
Avoid impulsive spending
In the age of instant gratification, impulse spending has become the new norm. However, this is how people often fall into debt traps. Using credit cards or loans to buy a bigger house or a new car may seem very easy, but it leads you to fall into an unintended debt trap. So, think carefully before flaunting anything on credit.
Prioritize your needs by selecting essential, semi-essential, and nonessential items. This will reduce discretionary spending and help you live within your means. Ultimately, proper awareness of your income, financial obligations, and regular expenses can nip the risk of falling into a debt trap in the bud.