What is a debt trap and how to avoid falling into it? – Advisor Forbes INDIA
The accumulation of debt has always been frowned upon. Nevertheless, there may be situations where one has no choice but to incur debt. This could include a home loan, an education loan, or a personal loan to handle unforeseen events or health emergencies.
Whatever the situation, it is best to avoid taking out multiple lines of credit. If this happens, one must ensure that he can repay these loans on time. It is essential not to overuse credit limits to avoid falling into the debt trap.
What is a debt trap?
A debt trap is a situation where a borrower is forced to take out new loans just to pay off existing ones. Essentially, a debt trap occurs when debt obligations exceed loan repayment capacity. Loans are repaid in two parts – principal and an amount of interest – over a predetermined fixed period.
A debt trap does not necessarily occur solely because of expensive or costly loans. If the borrower’s income is sufficient, a large loan can be repaid without hassle. Therefore, the loan amount cannot necessarily be equated with a debt trap.
However, if the equivalent monthly installments (EMI) are not paid on time, interest on the unpaid amount will continue to accrue and may include late payment penalties. This continues to inflate its overall debt.
In such a scenario, a borrower may possibly take out a new loan to repay the previous one. A small loan can also push the borrower into a debt trap if he cannot repay it on time and the interest component keeps increasing every month.
There are other reasons why people may involuntarily go into debt. For example, a person may have taken out an expensive short-term loan to overcome an immediate crisis. Or one may have borrowed a small amount but suddenly lost the ability to repay due to job loss.
Sometimes a borrower may have postponed paying off the debt in full, hoping to do so until they have received the payments owed to them and have more money available. However, if their plans do not materialize, they end up defaulting on their loan commitments.
Avoiding the debt trap is imperative because it has multiple implications. Apart from the financial and credit score consequences, this can lead to serious psychological and social problems. Therefore, proper management of funds and timely repayments are essential to ensure that one is not trapped in a debt loop.
Differentiate between good debt and bad debt
It is necessary to differentiate between good debt and bad debt. Yes, debt can also be good, although it may seem surprising. To understand this, debt must be separated into two types: income-generating and non-income-generating.
Debt incurred to purchase an asset that helps generate income for a long period of time is referred to as good debt. Conversely, a loan/debt incurred against an asset that does not generate income may be considered a bad debt. Of course, in the strictest sense of the term, a “bad debt” refers to a loan that cannot be recovered and must be canceled.
Avoid and manage debt
Getting out of any debt trap can be both stressful and difficult. To avoid falling into the trap of indebtedness, it is crucial to plan for your current and future financial needs, then to go into debt according to your ability to repay.
For example, a partial payment or only paying the minimum amount due on credit cards might seem like a good way to get things done. But if this habit continues for an extended period of time, a borrower may soon find themselves stuck in debt because high interest charges keep piling up.
One of the crucial ways to manage debt is to analyze the different types of debt incurred. Additionally, the total term, the specific interest rate of each debt, and the overall outstanding should also be considered and will decide how best to manage the debt.
Once these aspects are understood, one can prioritize the debts. It is then possible to know which loans will attract more interest and penalties if the payment is delayed and therefore must be repaid first.
Factors to help you avoid debt pitfalls
There are other important factors to streamline your repayments and avoid debt pitfalls. These include:
Creation of an emergency fund
One of the best ways to avoid the debt trap is to have an emergency fund. This can be done by ensuring that one has savings equal to 6 months salary set aside for emergencies. Such an emergency fund could help avoid the debt trap.
With an emergency fund, one can ride out a temporary crisis like losing a job and keep things running for a few months until the situation stabilizes.
Consolidate various loans into one
Servicing multiple loans at different interest rates can be difficult and stressful. This problem can be solved by taking out a single loan, for example a personal loan, to pay off the other loans, thus consolidating all debts into a single loan. This can make a borrower’s life easier and help them get out of the debt trap.
To elaborate, it is possible that some older loans will be repaid at higher interest rates. But you can go to a bank or other lender and look for a new loan at a lower interest rate to consolidate all previous loans under the new one. This could then significantly reduce EMI outputs.
Even if the repayment tenure increases to some extent, it will still be comfortable enough to manage cash flow and avoid a debt trap. Plus, you no longer have to worry about remembering multiple repayment dates. Outgoing debt on a single day then helps to better manage monthly expenses.
Check monthly expenses
Sometimes we tend to splurge without checking spending habits or spending heads. By tracking and budgeting monthly expenses, unnecessary expenses can be identified and prevented.
This helps eliminate unwanted spending and minimize discretionary spending to focus on the essentials. A disciplined approach to your monthly spending habits can reduce the risk of falling into the debt trap.
Balancing monthly debt service
A good way to protect yourself from a debt trap is to ensure that your total EMI expenses do not exceed 40% of net monthly income. In the case of a home loan, this percentage can go up to 50%. For this, one must take into account the net income after tax, provident fund (PF) and other deducted expenses.
The above point is critical because debt traps usually occur when a person’s monthly income is insufficient to meet their regular loan commitments.
Market value tracking of your home equity
This is essential to avoid negative equity in your net worth. Over the decades in India, house prices have generally only moved upwards. But over the past decade, property prices have fallen or stagnated in most geographies.
With this in mind, it is imperative to track your home equity, which is the current market value of the property less any mortgages, liens attached to the property, or unpaid principal.
The amount of equity in a home (or its value) continues to fluctuate over time as additional payments are made on the mortgaged property, while market conditions affect its current value.
Under normal circumstances, as one continues to pay down the home loan over the years, its value continues to appreciate and the equity in your home always remains positive. However, when real estate prices fall, the equity in your home becomes negative. This can put you in trouble as the bank or lender may ask you to provide more margins to compensate for the drop in value of the property. Constantly monitoring the equity in your property will ensure that you are not caught off guard financially.
Leverage cash flow to prepay high-cost debt
It’s a simple way to avoid the debt trap. When there is a temporary influx of funds such as capital gains on the sale of stock, an annual bonus, or the sale of ancestral property, use it to prepay costly debts such as personal loans, credit cards or automobiles.
When the high interest rate loans are paid off, you effectively save the extra amount that would otherwise have been used for the higher interest charges.
Avoid impulse spending
In the age of instant gratification, impulse spending is the new norm. Yet this is how people often fall into the debt trap. Using credit cards or loans to buy a bigger house or a new car may seem so easy, but it inadvertently pushes you into a debt trap. So think twice before splurging on anything with credit.
Prioritize your needs by identifying essential, semi-essential and non-essential items. This will limit discretionary spending and help you live within your means. Ultimately, knowing your income, financial obligations, and regular expenses can nip the risk of a debt trap in the bud.