Debt traps are one form of financial problems that many people and businesses get into. A debt trap occurs when one pays off one loan by taking another loan. To evade a debt trap, one must have a plan, discipline, and know how debt works. This article seeks to define a debt trap, analyze its causes, and devise ways to avoid being ensnared.
1. What Is A Debt Trap?
A debt trap is a situation that arises when you incur additional debt to settle existing debt. As is evident, this endless loop puts you in a situation where the newly acquired debt is comparatively more difficult to pay off. This cycle makes obtaining and managing new debt more challenging. If a person or business faces this situation, all options of taking on more debt would be extinguished, thereby leading to dire financial suffering.
Illustration of a Debt Trap
Let’s take an example of a salaried individual Mr. Ram who makes Rs. 50,000 every month. He has a car and home loan which he is progressively repaying every month. In case of an emergency, he is taking up a personal loan because he has no medical insurance. Currently, Mr. Ram is in a permanent debt trap due to a lack of savings and is borrowing continuously to pay off his existing loans. EMIs (Equated Monthly Installments) is completely consuming his income, which has resulted in an economic crisis for him.
2. Significant Factors for Falling Into a Debt Trap
To understand a debt trap better and to avoid falling into one, it is crucial to understand the factors that contribute to it. Lack of adequate financial planning is a key motive behind its emergence. Some of these important factors are enlisted below:
Incomplete Financial Planning
- Income versus Expenses: There is always a mismatch of payment towards a budget and income inflow. This results in people accumulating debt to meet their monthly expenditure.
- Loan Worthiness: Defaulting on loans is rampant as people are simply not willing to think of the long-term impact these loans will have on their finances.
- EMI Planning: More often than not, the society tends to overestimate their financial capabilities when it comes to taking out loans because EMIs are the norm now.
This e-commerce loan case study depicts how Mr. A has used the borrowed $30,000, – $40,000 while also highlighting the issues he is facing due to poor financial planning. Mr. A had great expectations from his e-commerce venture considering how well his business would do during the lockdown. To his surprise, he was unable to generate enough traffic on his website. The business was not only a failure, he was also facing issues with repaying the loan which he had taken to fund inventory, employee salary payments, and rent. Due to lack of planning in regard to business loans, he has ended up in a debt trap.
3. Understanding Interest Rates
While taking out loans, one must clearly understand the different types of interest that might include great factors in repaying the debt.
Simple Interest
As the name states, simple interest allows the principle amount to stay constant and does not allow for any changes. Here’s an example for better understanding:
- Principal amount: Rs. 1,00,000
- Duration: 3 years
- Interest rate: 10% per annum
The calculation method is as follows:
- Rs. 1,00,000 * 3 years * 10% = Rs. 10,000
This means that the simple interest received during that 3 year timeframe is Rs.10,000.
Compound Interest
When using compound interest, more funds are owed each succeeding year because the interest charged is compounded along with the principal amount.
- Principal amount: 1,00,000 Rs
- Duration: 3 years
- Interest rate: 10% for every year
In the second year, interest will be charged on 1,10,000 (original principal + interest from the 1st year). This increases the total debt at an escalated pace compounding interest.
Tip: Consider if the loan is calculated using simple or compound interest because it impacts the amount of money you owe, over time.
4. Avoiding a Debt Trap
To avoid falling for a future debt trap, adequate planning ensures safety of your finances. Below are some effective methods so that you stay debt free:
Financial Advisor
If you’re having trouble managing your finances, it may be wise to consult a financial advisor. A professional can help you budget, create a strategy for paying off a loan, and even ways to cut of expenses.
Rise Monthly Earnings
If what you earn is insufficient for your expenses, seek out additional forms of income through side gigs, investments, freelancing or part-time work.
Avoidable Expense Catering
The identification of non-essential expenditures is one of the bidding approaches to ensuring you do not fall Dep Debt Trap. Analyze your spending patterns and see how you’re spending your cash in each month and where you need to cut back on spending.
EMIs Pay Down Payment Sad mates
Set a strategy such that your loan payments should not stress you out. If these expenses exceed half your disposable income you will be unlikely to maintain it. As a general rule, never spend more than 40%-50% of your income on debt repayments.
Filing For Emotional Personal Bankruptcy
It might help to consider applying for personal bankruptcy is the business/employment side of your life is fundamentally stagnant. The court will take your taxes and has debts to pay and your assets to decide a workable solution for you financially.
Conclusion:
The conclusion is that in order to stay out of a debt trap, it should be more nuanced and dared to be opened from expense incurred planning, and discipline. You have to always keep in mind spending less than you make, making sure there is scope for starts improves income, nonpaying interest amounts, and taking loans dutyfully.
