What is a Debt Trap?
A debt trap is when one invokes debt and finds it impossible to repay that borrowed sum of money. This mostly occurs due to predatory lending, where customers are offered high interest rates and very short windows for returning the borrowed amount.
How and When do you get Into a Debt Trap?
A debt trap occurs when you make hasty or ill-informed decisions that are not well-thought of while availing credit. Consumers are at risk of a debt trap when their spending power and spending habits are not balanced
For example, if your monthly salary is INR 50,000, you will not have the purchasing power to buy a home theatre system, which costs upward of INR. 80,000. Credit options like cards, EMIs, loans, etc., enable you to make a purchase. And suppose you make a purchase thinking that you will be able to return the borrowed sum through EMIs.
However, the very next month, you are faced with a medical emergency you may not have forecasted or accounted for. This will make you incapable of repaying the borrowed sum, which will begin a vicious cycle of late payments, higher rates of interest, and much more.
So, prudence and frugality are essential when deciding your credit options. Use this finance mode only where there is an actual need because it is a big responsibility.
What are the Signs of a Debt Trap?
- If you have too many EMIs, it indicates that you do not have control over unnecessary spending and maybe an invitation for a debt trap.
- If you find the need to borrow a new loan to repay an existing loan, it is a red signal that you are marching towards a debt trap.
- If your fixed obligation-to-income ratio (FOIR) is higher than 70%, it’s time to recheck your spending. This ratio signifies your income, which certainly goes into fixed expenses every month, like EMIs, loan interest, rent, monthly bills, etc.
- Many people make the mistake of not clearing the entire amount on their credit card bills. They stick to making only the minimum payment due and keeps the other amount pending. This is a huge mistake and a sign of inviting a debt trap. Withdrawing cash using credit cards is also not a wise idea. You will be charged cash advance fees, and interest rates as high as 50% may also be levied.
- If your loan application does not get approved, it is a sign that either your credit score is weak or you have too many active ongoing loans. And this could signal an upcoming debt trap.
How to Avoid Getting Into Debt traps?
- Prioritise your needs: Borrow credit only where there is a sincere need, and make sure you are always able to repay the existing loans before applying for new ones.
- Consider debt consolidation: Instead of having to pay and manage too many debts, you can opt for a personal loan for debt consolidation. This helps aggregate all your debt payments and leaves you with managing only one loan, at possibly lower interest rates.
- Build an emergency fund: Create a contingency fund and make sure that you touch this fund only in case of an actual emergency.
- Avoid shopping on EMIs: EMIs can be very exciting, but they are one of the primary reasons for inviting a debt trap if not handled effectively. So, avoid making purchases on EMIs as far as possible.