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Debt Trap

If you have to borrow, repay, and consequently borrow again or roll over the repayments of the loan, as you are incapable of making scheduled payments on the loan, you are in a debt trap. In the following analysis, we seek to understand the debt trap meaning and ways to mitigate the same.

What is a debt trap?

A debt trap is a difficult situation where a person cannot repay the loan they have secured. They have to borrow again and the cycle continues. This can happen due to a change in interest rate regime or terms of the loan which leads to a default of payment and bankruptcies. It leads to financial hassles for individuals and is a cause of concern. Defaulting in interest payments worsens credit score. It further makes it tough for the individual to borrow money from banks at a manageable interest rate. In addition to this, the loan application may not be approved. Insurance premiums will be higher. Funds will be tougher to collect for entrepreneurs.

 

How does a debt trap work?

At the onset, it is pertinent to understand how the debt trap works. When you borrow money from a lender (say a bank), you have two things to deal with. Firstly, the principal and lastly the interest. Consequently, interest payments are made every month. However, if the principal begins reducing it can then be subsequently termed as progress. Furthermore, the principal and interest are paid until the loan is finally paid off. It is due to the amortizing nature of the loans.

If you are unable to make the regular payments, you will default and fall into a debt trap. The principal is subsequently not reduced and the interest keeps increasing making it impossible to be cleared.

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Signs that you are stuck in a debt trap

1. EMI’s are over 50% of your salary:  Commencing with easy finance at doorsteps, people have become extravagant. The discounts and sales are easily tempting them to go for EMI’s. The EMI’s might appear as a small amount but in summation, they can be quite higher. It can leave less money for spending on other important things.

2. Fixed expenses exceed 70% of your salary: EMI is not the only issue that needs to be dealt with. There are other expenses like house rent, school fees, utilities, etc. that need to be paid. Without question the fixed expense to salary ratio has to be 50%, exceeding which can become a problem.

3. Overshooting Credit Card limit: It is convenient to swipe and buy things you want. There is no need to worry about the immediate payment of the bill. If the credit limit is over it is a warning signal. You must rethink your financial strategy as you may in a debt trap.

4. Too many loans:   To take a case in point, paying many EMI’s in a month it tends to dry the motivation, and the outflow of money is huge. It concurrently puts a risk of defaulting.

5. Unable to save money: If you are not able to save money every month it is a serious issue. It is also a signal that you are in a debt trap.

Debt trap

How to Get Rid of it?

1. Identify the problem and tackle it: Doing a thorough analysis of your expenses can help you locate the problem.  Check the areas that are forcing you to fall into a debt trap. Lastly, make a plan to address it.

2. Prioritize your needs with a budget: Segregating essential, not so essential, and inessential needs should be done post debt analysis.

3. Debt Consolidation: Having to pay different loans at different times in a month conversely you should opt for a debt consolidation loan. You will be making one payment to one lender each month. This helps in saving money, EMI’s are paid on time and debt gets disposed of faster.

4. Regularize the online payment: Setting up an ECS with your bank can help you regularize your scheduled payments. It makes the debt go off faster and your credit score gets a boost.

5. Don’t borrow more: One should stop borrowing in addition to the existing loans. Never exceed your debt to income ratio by more than 40%. 

6. Increase your income: You should find ways to increase your income. It can be a freelance gig or a part-time job as it helps in paying off debts faster.

7. Pay the costly loan first: You can pay individual debts separately in the event of not choosing a debt consolidation plan. You will have to pay the expensive loan first.

8. Credit Score is important: Credit score monitoring is important. A good score bodes well for a borrower as lenders prefer to attend to them and offer the best interest rates. A 750 credit score is a good rating.

9. Seek professional help: In case you are not able to manage your debt repayment plan, you should consult finance professionals. 

Debt trap

Conclusion

It is easy for a person to buy everything they want and opt for EMI’s in the times of flashy sales and deep discounts. On the face of it, EMI’s appear benign but when they get added up the final amount is huge. Not paying attention to your spending behavior can make you a victim of debts.

More than 15% of respondents of an ET Wealth 2019 survey had an EMI outgo of more than 50%. It can lead one to borrow more money and eventually exhaust their income in repaying loans.

It is thereby advisable to prioritize your loans through debt consolidation plans and maintain the financial discipline to keep a check on your spending. Checking your credit score is considered good as it keeps you on right track. Seeking professional help from finance experts can help you find a logical solution to your debt problems.

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