What Is Debt Trap?? Mistakes to Avoid While Taking Debt

Debt Trap –The term itself indicates that an individual is stuck in a situation and struggling to get out of it. Debt means money one owes to other person. Debt is used by many individuals and companies to make large purchase that they could not afford under other companies to make large purchases that they could not afford under other circumstances. Debt Trap is a situation where one is forced to take new loans in order to repay existing debt obligations.

Such a situation arises when debt obligations exceed repayment capacity and the income generated becomes insufficient to clear the debt. The interest outstanding on the loan begins to pile up and the individual will again need to take loan to repay the existing ones.  Let us understand in detail what is debt trap and what mistakes should be avoided while taking debt.

What is meant by Debt Trap??

• Debt trap is a situation where a person borrows so much money that it becomes difficult for him or her to repay and thus the debt keeps piling up and this becomes a trap for the person. If the person is totally unable to come out of debt then he or she becomes bankrupt and seeks help from the court to resolve the issue.

Causes of Debt Trap

1. EMIs Exceed 50% of Income

• EMI Schemes and Discount that too of a compulsive nature might strain the budget and make oneself fall under a debt trap. Therefore one must be mindful about the finances.  If the home loan EMI exceeds more than 50% of a person’s income, then he or she will not have sufficient money left to pay the monthly bills or invest in other things. While individual EMIs may seem manageable, the cumulative effect of multiple obligations can leave you with limited funds for other expenses.
• While there isn’t a universally defined threshold for an acceptable EMI outflow, most experts recommend it to be less than 50% of one’s monthly income. Many banks also set limits to prevent individuals from exceeding this 50% threshold. Additionally, besides fixed EMIs, one must consider the repayment of soft loans obtained from friends or family when evaluating financial obligations.

2. Fixed Expenses are More

• EMI constitutes just one component of an individual’s fixed obligations. Other fixed expenses, such as rent, society maintenance charges, and children’s school fees, contribute to the overall fixed obligations. Ideally, the fixed obligations-to-income ratio (FOIR) should not exceed 50%.
• Although achieving the 50% FOIR might not be feasible for everyone, surpassing the 70% threshold serves as an early warning sign of potentially entering a debt trap. Experts emphasize the 70% mark because individuals require at least 30% of their monthly income to cover additional expenses and save towards financial goals.

3. Credit Limit exhausted

• Borrowing for routine expenses to settle loans is unwise, and using credit cards for such purposes is a guaranteed method of encountering difficulties. Withdrawing cash through a credit card incurs a substantial cash advance fee, typically ranging from 2.5% to 3.5% of the withdrawn amount each month. On an annual basis, the associated interest can accumulate to a significant 35% to 50%. Failing to settle credit card dues in full raises a significant concern.
• According to our survey, this practice of not paying the entire credit card bill is widespread. Approximately 21% of respondents have either missed a credit card payment or opted to roll it over by paying only the minimum due amount in the past year. Many individuals may not fully comprehend the substantial costs associated with such rollovers. The allure lies in the low minimum payable amount, leading people into this financial trap.
• The true predicament of carrying forward credit card balances is the imposition of a high-interest rate, typically around 3% per month. If you find yourself caught in this rollover cycle, it is crucial to prioritize escaping it promptly. Procrastination will only exacerbate the issue. Consider leveraging some of your investments, especially those not tied to specific goals, to break free from the rollover trap. If repaying the credit card dues in full remains challenging, exploring  the option of transferring the outstanding balance to a lower-cost loan is advisable.

4. Multiple Loans

• Borrowing money to repay a loan, unless the intention is to reduce interest expenses (such as in the case of refinancing a home loan), raises concerns. Another troubling indication is how individuals manage their fixed obligations. Typically, people are hesitant to default on home loan and car loan EMIs, as well as payments like rent and school fees, due to societal pressures. Instead, some resort to extensive use of credit cards, attempting to manage credit card bills by paying only the minimum required amount. This is a significant reason why cash withdrawals and the rollover of credit card dues are unacceptably high for many individuals.

      5. Loans with rising EMIs

• Many individuals tend to overestimate their future salary increments. In the initial stages of one’s career, increments are typically higher, given the smaller base. Relying on the assumption that these increments will persist until retirement for the purpose of taking larger loans may not be a prudent strategy.
• Financial institutions also contribute to these potentially unhealthy habits by offering loan products with increasing EMIs over time, often after a few years. Since many people opt for floating rate home loans, they should be prepared for sudden spikes in EMIs resulting from interest rate hikes. It is advisable for individuals to factor in a potential 20% increase in EMIs due to rising interest rates and allocate contingency funds specifically for loan repayment.

How to Avoid Falling in to Debt Trap??

If one person is already in a debt trap coming out of it is really a difficulty. However there are certain steps which if followed one can come out of the debt trap

1. Check Priorities

• Sometimes people spend their money without checking their expense heads and spending patterns. To avoid this it is essential to create a priority list and segregate the needs. The first thing one should do is to categorize needs in to essential, semi essential and non-essential. In these try to focus on only essential items. By making budget and tracking monthly expenses one can identify and prevent wasteful expenses.
• These will minimize discretionary and unwanted spending and focus only on necessities. A disciplined approach will guide to improve spending habits and help reduce risk of falling in to debt trap. To avoid spending recklessly prioritize the needs.

2. Build Emergency Fund

• An emergency fund is a fund that should help you carry on with life and meet your obligatory expenses without opting for last-minute unplanned loans, over utilizing your credit card, or selling and mortgaging your existing assets. 
• For your emergency fund, you may need to factor in obligatory expenses which are those expenses that are absolutely necessary.  Ideally, obligatory expenses include expenses for food and medical treatment, rent, monthly instalments of loans, school fees, basic repairs and maintenance, insurance premiums and anything that you feel is indispensable. 

3. Avoid Taking More Debts

• When you seek a car loan, mortgage, student loan or personal loan, opt for the smallest one possible that will help you meet your goals. Making a sizable down payment on a car or mortgage can lower your ongoing monthly payment. Choosing to borrow through a credit union may help you get lower interest rates on loan products.

4. Get Rid of High Interest Loans

• Debt may be impossible to avoid if you’d like to buy a house, go to college or buy a car. But you could limit your monthly payments and get a lower interest rate with a good credit score, which is generally considered 700 or above. The higher your score, the more likely it is that a lender will not only accept your application, but that you’ll get the best terms possible, saving you money.

5. Automate EMI and utility Bills

• To be able to use this facility, your bank needs to go live with the E-Mandate option. Only after E-Mandate goes live will you as a customer be able to enable the facility for your bill payments. NPCI has allowed certain merchant categories to use E-Mandate. E-commerce is not part of it, but insurance, mutual fund houses, fintech companies and utility service providers can enable it. The purpose of E-Mandate is to facilitate financial payment that has a collection requirement. The NPCI will levy a fee for using the service. While this is convenient, it also means you need to leave enough balance in your account to meet all payment requirements.