For the majority of our financial demands, borrowing is a convenient choice. Without depleting your present savings or financial resources, you may purchase everything you like. If you don’t handle your bills responsibly, you may find yourself in a debt trap. A debt trap is a financial scenario in which debtors become imprisoned in a never-ending loop of re-borrowing, making it difficult to repay the borrowed funds. High-interest rates or borrowing too much money in a short period of time are the most common causes of debt traps. Debt traps can have a negative impact on your financial situation. In this article, you will read everything about debt traps, including what a debt trap means, the reasons for a debt trap, and how to prevent and escape them.
Everyone wishes to be financially independent. However, this may not always be straightforward. This does not imply that one must be debt-free. Becoming completely debt-free would not be a wise decision. On the contrary, taking out a loan now and again to give yourself a financial boost is a good idea.
While it may be prudent to take out loans from time to time, it is also necessary to guarantee that they are paid back on time. You may avoid getting into debt by making smart debt repayments. While financial independence is a goal for everyone, achieving it may need some strategic manoeuvring.
Debt Trap Meaning: What Is A Debt Trap?
In technical words, a debt trap means a circumstance in which your debt escalates out of control. This is what happens when you consume more than you produce. Unexpected events, such as a desire to pursue further education or a lack of preparation, might result in years of debt repayment. There are, however, methods to prevent sliding into a debt trap. There are other ways to break out of a debt trap if you find yourself in one. The trick is to be alert and pull yourself together.
The 2 Most Reliable Indicators Of Debt Trap
A debt trap can be identified by two trustworthy indicators:-
EMI-Salary Ratio: Your EMI-salary ratio is 0.5 if your EMI is Rs. 10,000 and your take-home wage is Rs. 20,000. This ratio should be less than 0.3, according to experts.
Loan-Asset Ratio: Your debt-asset ratio is 2.5 if your loan balance is Rs. 25 lakhs and your equity is Rs. 10 lakhs. This ratio should be less than 0.5, according to experts.
How Does Debt Trap Start: What Are The Reasons For Debt Trap?
Reducing credit score – Your credit score is the most accurate predictor of your capacity to repay debts. Maintaining a good credit score necessitates regular debt payback. The primary reason for the debt trap is a poor credit score. Therefore it is advised to look for areas where you may have financial problems and try to fix them. For example, you may have overextended yourself in your monthly budget and missed the payment date. In this circumstance, you should get a waiver on your late EMI payments if it is the first time, and then set up repayment reminders and set aside the appropriate amount for your loan EMIs from your monthly wage to avoid late payments. If you pay your personal loan EMIs on time, your credit score will be re-energised.
Multiple loans – Your budget might become quite tight if you are balancing the payback amounts borrowed from your peers, many personal loans, and credit card payments. You can combine all of your debts under one loan umbrella and have a single monthly payments window in this circumstance. This ensures prompt payments and peace of mind.
No savings – Don’t worry if you haven’t begun saving yet. It’s never too late to start putting money aside. Saving money is critical to achieving your long-term financial objectives. Consider mutual funds, ULIPs, retirement plans, and fixed deposits to begin saving. You may take advantage of compound interest by investing consistently in such schemes.
EMIs are greater than 50% of income – When you routinely spend through EMI plans or discounts, which many people fall prey to, compulsive spending limits your budget and leads to debt traps. As a result, it’s critical to be aware of your money before engaging in excessive spending. If your EMI payments account for more than half of your income, you’re in trouble.
Taking a loan for regular payments – You may be falling into a debt trap if you find yourself borrowing money to cover monthly obligations like rent, kids’ school fees, supermarket purchases, and so on. If you find yourself in this scenario, you should focus on paying off your obligations as quickly as possible and avoiding the temptation of taking on more debt.
How Does Debt Trap Work?
When you take out a loan from a moneylender, two factors come into play: the main loan amount (the amount you borrow) and the interest rate (the amount the lender charges on the principal loan amount).
Only when your principal starts to decrease can you make progress on your loan. However, there is a snag. When you make a monthly payment on your loan, you are paying both the principal and the interest. Because most loans have amortising arrangements, this is the case. That means your loan is structured to be paid off in a series of set instalments over the course of a loan term, with each payment applied to both the principal and interest.
You’re more prone to get into debt if you can’t afford to make payments.
The main amount does not decrease, and the interest accumulates, making it nearly hard to repay your debt.
When Does The Credit Push The Borrower Into A Debt Trap?
Applying for more credit or a loan in a high-risk position might cause complications or lead to a debt trap.
A baker, for example, may take out a loan to purchase raw ingredients for his bakery. The individual is having difficulty selling the final things due to poor demand. The store owner takes out a new loan to sell fresh things to recuperate from the loss and repay the previous debt.
Unfortunately, the person falls prey to the same circumstance again and is unable to repay the debt. A debt trap is a circle of debts that the borrower finds difficult to escape.
How To Come Out Of A Debt Trap: 8 Ways To Overcome A Debt Trap
If you’ve already fallen into a financial trap, getting out might feel impossible. When a borrower misses a debt payment, it becomes harder to get lower-cost loans to cover the current obligations, increasing the debt load. Although breaking out of a debt trap is challenging, the following measures can assist you in doing so:-
Understand the problem
A thorough and rigorous examination might provide the solution to your current debt predicament. Here are some options:
- To begin, you must recognise and confess that you have a debt issue.
- Determine which areas are leading you to slip into debt.
- Make a plan to address these issues.
- Make a budget and list your priorities.
- Make a budget and list your priorities.
You may now be able to determine necessary, semi-essential, and non-essential costs after a comprehensive examination of your financial status.
Create A Priority List
Make debt repayment your first priority since it might help you improve your financial status in the long run. At least until you get back on track, refrain from indulging in non-essential or even semi-essential products.
Opt For A Debt Consolidation
Rather than repaying many loans at different times throughout the month, consider combining your high-interest debt with a low-interest personal loan or a debt consolidation loan. After debt consolidation, you’ll just have to worry about paying one monthly payment to one lender. As a result,
- You have savings on interest,
- You pay timely EMIs,
- Your debt gets cleared faster, and
- You regain financial strength
The financial commitment you make with your lender is to repay your loan in EMIs. You can avoid breaking this guarantee by automating your payments. The following are some of the advantages of putting up an ECS mandate with your bank to automate repayments:
- You always pay on time.
- You save money on interest, late fees, and penalties by making timely payments.
- Your credit score improves.
- Avoid adding to your debt.
Avoid taking out extra loans when you’re already in debt. Make it a rule that your debt-to-income ratio should not exceed 40%. Otherwise, you’ll be putting so much strain on your money that if you lose your job, you’ll be in serious financial trouble.
Increase Your Income
Increasing your income is one strategy to get out of debt. You may utilise the additional money to pay down your debt faster. Find freelance work or a second (part-time) employment that is a good fit for your abilities, expertise, and experience.
Pay Off Expensive Loans
If you don’t want to consolidate your debts and instead want to pay them off one at a time, make a strategy to pay off the most expensive loan first.
Frequent Checks Of The Credit Score
A high credit score defines a good borrower. If your credit score is 750 or higher, you will be eligible for the finest lenders, interest rates, and loan terms. So, if you want to have a secure financial future, you must monitor your credit score. Request your credit report at least once every three months or when a loan account has been closed. Examine if the information recorded is accurate and meets your expectations.
Get Professional Help
If you’re having trouble getting out of debt on your own, it’s essential to get advice from a professional. Financial specialists may provide financial advice and set spending limitations for you. Some specialists may even speak with the lender on your behalf in order to improve the loan conditions.
How Does Debt Consolidation Help You Come Out Of A Debt Trap?
Debt consolidation is one of the most effective methods for improving your financial status. If you have many high-interest loans or credit card balances, you’re progressively preparing for a financial disaster. Getting a low-interest personal loan is a smart way to get out of debt. The personal loan lets you pay off all of your existing debts and consolidate your payments into a single monthly payment for your debt consolidation personal loan.
Why is it beneficial to take out a debt consolidation loan?
- You may cut your interest rate, lower your monthly payments, and pay off your debt faster with a debt consolidation loan.
- It improves your financial independence and assists you in effectively budgeting your monthly costs.
- You lessen or eliminate the possibilities of skipping payments by making a single monthly payment rather than many loan EMIs, avoiding late penalties and higher interest rates.
- It guarantees on-time payments, which raises your credit score and makes you more creditworthy for future loans.
Apply For Instant Personal Loan From Loaney To Consolidate Loans
If all else fails, you can replace your high-interest debt with a low-interest personal loan. For example, if you’re having trouble paying off credit card debt with a 40–45% interest rate, you can get a personal loan to help you out. You can take out a Personal Loan to get a loan that is tailored to your debt demands. Furthermore, when you choose Loaney Personal Loans, you enjoy extra perks such as flexible repayments, interest-only EMIs initially, and more. Visit Loaney’s website to apply for a Personal Loan or learn more about it.
Loaney is a unique online supermarket that caters to all of your personal and financial requirements. Loans, insurance, investments, and a unique EMI shop are all available under one roof, at any time and from any location, with the help of personal loans.
Having a good handle on your finances might help you achieve financial independence. Keep track of your income and expenses to see how you’re spending your money. Remember that taking out a loan might be beneficial since it can help you handle a pressing financial problem. Paying it down on time enables you to avoid exorbitant interest rates and achieve your financial goals.
Frequently Asked Questions
What are the reasons of the debt trap?
It’s critical that you recognise the factors that might lead to you falling into debt. Some of the reasons of the debt trap are:
- Your EMIs account for more than half of your income.
- Your fixed costs account for more than 70% of your revenue.
- Your credit card limit has been reached.
- You have an excessive number of loans.
- You just cannot afford to put money aside for savings.
- Your loan application has been turned down.
What is an example of a debt trap?
When a borrower is unable to repay a prior loan, he takes out a new one. This is known as the Debt Trap.
Ex: Ram has taken a loan to pay his son’s fees, but he is unable to repay it, so he obtains a second loan to pay the fees.
In a financial trap, getting out of debt is extremely difficult.
How do you escape a debt trap?
- Recognise the issue.
- Prioritise debt repayment.
- Make a payment plan and fill in the gaps.
- Make sure you have enough insurance.
- Request a loan extension from your bank.
- Increase your EMI contributions and payments.