Many expenses, such as weddings, higher education or buying a home, require surplus funds. If you do not have surplus funds, taking loans from banks is the first thing that comes to your mind. Taking loans to fulfil your financial needs is the most common and feasible decision, but it is essential to check your debt-taking capacity. If you overburden yourself with loans and EMIs, you will likely fall into a debt trap.
Did you know? As of May 2022, there were more than 12,000 loan defaulters in India.
What is a Debt Trap?
A debt trap is when you take multiple loans beyond your capacity to repay and then take further loans to repay those loans. It creates a vicious cycle of debt that leads to increased borrowings, high-interest rates and high EMIs. Using multiple credit cards, defaulting in repayment of credit card dues, delaying or defaulting in timely payment of loan instalments, and compulsive spending habits are reasons for the debt trap.
The meaning of debt trap can be understood with the help of an example. Suppose you take a loan to buy a home, your home loan is outstanding, and you spend your savings on its furniture and interior work. Another part of your savings gets used in a medical emergency. Now that you have already taken a home loan and exhausted your savings, you take a personal loan to buy a car. With two outstanding loans, a major part of your monthly income is likely to be consumed in paying the EMIs of these two loans.
Therefore, you decide to avail of a credit card facility to meet your monthly expenses. In such a situation, you might get trapped in a debt trap with multiple debts and an adverse EMI-to-income ratio.
What are the Reasons for Debt Trap?
- Unplanned expenditures.
- Taking loans at high-interest rates due to a low credit score.
- Compulsive spending habits, not preparing or not sticking to your budget.
- Default in timely repayment of loans.
- Medical or health emergency that exhausts all savings.
- Overuse of credit cards.
- Unhealthy financial habits, like spending more than your earnings and not maintaining emergency funds.
- Not planning your investments and savings for future needs.
- Focusing more on your wants rather than your needs.
- Not tracking your expenses.
How to avoid a Debt trap?
Proper planning, calculated expenditures and savings can help you avoid a debt trap. Here are some strategies to avoid the situation of debt trap:
1. Analyse Essential and Non-Essential Needs
It is essential to prioritise your needs and spend accordingly. There are various types of financial requirements. For example, buying a home or higher education can be a priority, while spending on a luxurious car can be delayed. The priorities differ from person to person based on income and financial needs. You should categorise your financial needs to decide the amount and tenure of the loan to fulfil that need.
2. Debt Consolidation
If you have multiple loans outstanding, you should opt for debt consolidation. Instead of paying higher interest rates on different lenders, you can take a low-interest personal loan. You can pay off your small loans in one go. It can help you avoid piling up interest on the outstanding principal amount. Thus, you can use the debt consolidation measure to escape the debt trap by paying out your loans.
3. Choose the Auto-Debit EMI Option
You must select the auto-debit EMI option to avoid missing the payment of instalments. When processing your loan application, the banks allow you to choose from manual payment of loan instalments or automatically deduct the instalment amount from your account on a set date. The auto-debit option can be more convenient for you as you do not have to remember the repayment date.
4. Repay Loans On Priority
The borrowers tend to incur further expenditures instead of paying the old loan in full. This creates a burden of loan liabilities for you. The unpaid principal amount also keeps increasing, resulting in higher interest charges. If you do not want to pay excess interest, then you should pay off your old debts as a priority before taking new loans or incurring new expenses.
5. Repay High-Interest Loans
If you receive a bonus or hike in your income, you should utilise the surplus amount to repay the loans with higher interest rates. Paying off your expensive loans is essential to maintain your EMI and income ratio. If you repay the outstanding principal amount of high-interest loans in lumpsum, you can overcome the burden of loan liability in a lesser time.
6. Create and Maintain Emergency Fund
It would help if you wisely apportion a share of your monthly income to create and maintain an emergency fund. This emergency fund can save you from a sudden cash crunch in the event of a health issue or medical emergency. An emergency fund for unforeseen situations reduces the chances of procuring hasty loans at higher interest rates. If you do not maintain an emergency fund for unforeseen circumstances, you might end up exhausting your savings. Consequently, you must depend on loans and credits for your other financial requirements. This can create a situation of debt trap and destroy your financial freedom.
7. Limitation of Credit Cards
Having multiple credit cards can lead to overspending. Therefore, it is better to limit the number of your credit cards. Another disadvantage of having multiple credit cards is that your credit score may get adversely affected, which can result in costly finance from banks. The lenders might assess you as a risky borrower. Also, keeping track of your credit card dues and regularly paying your credit card bills on time is difficult. It is better to keep your expenditure within the limit of your earnings and follow a disciplined approach in paying off your credit card bills to avoid a liquidity crunch and stay safe from the debt trap.
8. Pay Credit Card Dues
Credit cards might give you an illusion of an increased spending capacity. But you should not over utilise your credit card limits. To avoid the debt trap, it is necessary to keep track of your expenditures and spend your money consciously. Pay your credit card dues timely if you do not want to get trapped in the interest and overdue charges that can affect your financial independence.
9. Checking EMI and Income Ratio
Your monthly loan instalments shall not be more than 30% of your monthly income. If the ratio of your EMIs is more than this, it can drive you into a debt trap. You should analyse your credit-taking capacity to maintain a balance between your earnings and loan liabilities. You should avoid taking credit from a new source to repay your old credit.
10. Strive To Increase Earnings and Lower Loan Liabilities
It is important to increase your earnings per your requirements. Once you increase your earnings, you should strategically attribute your earnings to savings and investments. A balanced approach of utilising your income for expenditure, saving and investment can maintain your financial stability and reduce your chances of falling into a debt trap.
Financial planning is a key to unlocking financial freedom and growth. If you fail to plan your expenses, savings and investments per your income, it can be difficult for you to avoid the debt trap. If you do not want to overburden yourself with unnecessarily higher instalments and loan charges, you should refrain from spending more than your capacity. You should maintain a budget for your requirements and keep your expenses within it.
Follow Khatabook for the latest updates, new blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounts.