What is A Debt Trap?

There is a famous saying which goes “Biting off more than you can chew” meaning agreeing to do, a task or responsibility, more than you actually can. Imagine you are really hungry, and you visit a restaurant. The restaurant has special offers on various cuisines. Even though it’s just your friend and you, you end up ordering 6 dishes, after eating the 4th dish you know you won’t be able to reach the last dish which is the dessert.

A debt trap is just the same, it is a situation where you have a lot of debt to pay out due to limited resources, multiple EMI’s, or high-interest rates. One might end up taking fresh loans just to clear off previous ones, and before they know it the situation spirals out of hand and they are buried neck-deep in financial distress. Debt is already a “code red” word. It brings with it interest and distress and/or anxiety. Although sensible debt obligations can be handled with ease, if the debt mountain grows unattended then it can do more harm than good.

The first step to solving any problem is the easiest yet the most difficult one to take: Acceptance. Accepting that you have a problem will set in motion a series of events that can help you come out unscathed from your financial troubles but staying in denial will lead you further down in trouble until you reach the hardest point from which amendments to your situation can seem impossible.

While you now know that things are a mess it’s time to act. Make a list of all that you owe; Credit cards, personal loans, home loans, vehicle loans, education loans, loans from friends and family. Rank these loans in order of high cost and in order of total loan balance to be paid. Once it is clear what you owe to whom and how much you can go towards finding solutions to the problem at hand.

Let us understand the 4 major signs that you should be able to see to accept that you are indeed in a debt trap.

Are You in a Debt Trap? 4 Signs to figure out your position:

1. Borrowing for survival:

One of the first signs of being in a debt trap is when you have to borrow funds for routine activities. If you borrow funds to pay off your monthly rent or for your child’s school fees, you are almost in a debt trap. Another warning sign that can signal your entry into a debt trap is using credit cards for basic needs and expenses.

2. Dipping into emergency funds:

If you miss a repayment obligation, it is likely to dip into your emergency fund. But if this becomes constant, it is a cause of worry. An emergency fund should at least be three to six months of your monthly income. If you are constantly reaching out to your emergency funds for help in obligation repayments chances are you’ve slid into a debt trap.

3. Paying off one loan with another:

If you take a loan to pay off another loan, either to buy time or by being lured to do so by bankers, what one should remember is that you have to pay off the loan sometime. You are entering a clear debt trap if you are indulging in this as an option. If you take on a personal loan for your home loan EMI installments what you are ignoring is that there might be a higher interest rate on such loans that might eat off your incomes and make you slide further in your debt troubles.

4. Monthly expenses are exceeding monthly income:

Another clear sign that reads code red for your financial stability is when your monthly expenses exceed your monthly income. According to a survey by ET Wealth, 15% of the respondents had an EMI outgo of more than 50%. Adding to this other obligation such as general expenses and/or various other loan repayment obligations, one’s expenses go way overboard than their liking.

If the Answer to the above question is YES! Here are 6 ways to find your way out of it.

1. Reduce your expenses:

The first step after identifying and accepting that you are indeed in trouble is to reduce unnecessary expenditure. Identify your spending habits, are you an emotional spender, or a compulsive buyer or you regularly order in or eat out. Once you know the root cause of your excessive spending you can put a full stop to such impulses.

2. Get rid of expensive loans first:

The most logical step in taking on your “Debt Trap Monster” is to do away with expensive loans that you have to repay. Pending Credit card bills amount to around 24%-40% interest rates, since any investment will not be able to generate such huge returns, practically this loan should be the first one to go. The next in line can be Home loans and Personal loans.

3. Identify assets that can be sold:

Make a list of all your investments that can be dissolved to help you dissolve your debt trap. Liquidating low-return investments, selling your old car, liquidating your fixed deposits, etc. Can be some assets that can be sold off. Before considering any such action one should be aware of their current financial obligations, or the number of dependents in your family, and whether or not you have a sufficient emergency fund.

4. Restructure and consolidate your debt:

If you have multiple loans with varying interest rates, one can consider communicating to the bank to consolidate all the loans into one and thereafter restructure the interest rate accordingly. This can bring down the interest rate and make for easier EMI payments as you only have to look at one loan to dispose of. Once you restructure your debt do not take fresh loans, as it will become counter-productive to getting free from the debt trap.

5. Identify loopholes in your spending:

When you face the problem of tackling your debt trap, you need to become better at your savings. As mentioned earlier, take a conscious note of your spending habits and take active efforts to control your impulses. Also keep a check on your spending via credit cards, because this can add on to your loans without your active consideration while also attracting higher interest rates.

6. Know the strategies to adopt to overcome Debt Traps:

There are 2 strategies one can consider when faced with the debt trap situation

i) Debt Avalanche Strategy:

This is a strategy when you start by paying off loans with the highest interest rates, not taking into account the total balance of loans taken. For example, you have a credit card outstanding bill of Rs 40,000 at a 24% per annum interest rate, and you also have a personal loan with an 18% interest rate. This strategy would need you to pay off your credit card bill first as it has a higher rate of interest. Dispensing off loans with higher costs will help you relieve stress from the debt trap pile.

ii) Debt Snowball Strategy:

This is a strategy where you will start off dispensing your obligations by the payment of the smallest debt balance. Once that is paid off you will move on to the next smallest amount that can be cleared. Unlike its counterpart, the focus of the Debt Snowball Strategy is on the balance of debt, not the cost of it. One thing that needs to be kept in mind while adopting nay strategy is that you will not focus on just one loan to repay, you actively have to make small payments towards each loan obligation while also focusing on returning the loan with higher interest or clearing off the smallest amount, as suitable to you.

Additional Gyaan: How to Avoid falling into a debt trap, Keep these 4 Tips In Mind

Here is a list of things one needs to keep an eye on to ensure that they do not slide easily into a debt trap:

1. Alter your lifestyle:

Make sure to plan out your monthly expenditures at the beginning of the month. This will help you with curbing additional spending, and also provide a window to you where you can benefit from saving some additional cash every month.

2. Build an emergency fund:

All the while you are dispensing your obligations there should always be an additional pool of funds that can cater to the emergency needs of you and your family. Having an emergency fund can thus be very beneficial in this aspect. Not only hospitalization expenses are adjusted with these funds they also can provide a cushion where you don’t have to borrow additionally for dispensing small amounts from your loans.

3. Credit card bills:

Make sure that you pay your credit card bills on the due date. This can be beneficial for 2 purposes; Firstly, the interest rates on credit cards are very high at around 40 per cent, and the inability to pay off the bill is very expensive and Secondly, paying your bills on time will do good for your CIBIL score which can further help you in getting funds.

4. Personal loans:

While it’s easy to get a personal loan when we need it if we have a recurring income, we ignore the high interest rate on personal loans that eats away our recurring income later. For vacations, funding education, or even for marriage, funds can be saved actively from earlier on. This will lessen dependency on a personal loan. Keep personal loans as an option for when there is an emergency that can’t be avoided.

Now, while taking on debt is not an issue on its own, how will you repay it, is what you need to consider even before taking one. A proper Debt Plan should be constructed that should include the Who and How; From whom you will take the loan and How will you repay it. Set a fixed date to close all debts and make your best effort to stick to it.

Planning out your monthly finances can be a step closer for you, to achieve financial freedom. Keep a track of expenditure and incomes and keep a track of how the incoming funds are to be managed towards expenses and loan repayments.

Taking a loan can be good for you, it can help you solve a financial problem, and having a plan beforehand on knowing how to repay the loan on time will safeguard you from higher interest rates and of course unnecessary stress.

Manoj Amarwal

Saarthi Dream
(Saarthi for your financial dream)