Loans are taken to gain a financial advantage, and sometimes, they are taken to satisfy your financial needs. However, when this facility is misused and made a necessity rather than treated like a luxury, you are bound to fall into a debt trap.
What is Debt Trap?
As the name suggests, the debt trap is a never-ending situation where you take loans on top of loans to pay off the existing ones. Over time, this spiral can zoom out of control to the point you exceed your repayment capacity.
Some say debt traps exist because you take high amounts of loans; however, high-ticket loans are not why you may land in this situation. If your income is enough to repay big loans on time, you won’t fall in a debt trap. So, equating the loan amount with a debt trap is not justified. Rather than blaming the loan amount, one should reconsider their repayment capacity as non-payment of EMIs and piled-up interest rates contribute to inflating your debt.
How to Spot a Debt Trap?
A general rule of thumb is to keep your EMI-salary ratio below 0.3. For example, if your EMI is ₹20,000 and your monthly take-home salary is ₹80,000, your EMI-salary ratio is 0.25, which is considered an excellent balance. To calculate this ratio, add up all your monthly instalments and divide the result by your monthly take-home salary.
Another indicator of debt trap to look out for is the loan-asset ratio. The recommended ratio for this category is below 0.5 and is calculated by dividing the loan balance by the net asset. For example, if you take a loan of ₹25 Lakh and ₹10 Lakh is your net asset, your ration will be 2.5, which is greater than the recommended ratio.
How Does a Debt Trap Work?
When borrowing a loan, two factors come into play – principal loan amount and interest rate. The principal loan amount is what you borrow from the financial institution and interest rate is what the lender charges on the total loan. To progress in the loan, you need to reduce the principal loan amount. But, when you make the monthly payments, you pay on the principal as well as the interest rate. You fall into a debt trap when you cannot pay back the total loan amount. This happens because you keep piling the interest rate on the principal loan amount and penalties for late repayment.
What Are the Signs That Indicate a Debt Trap?
Deteriorating Credit Score
Lenders check your credit score before approving your loan because it is one of the best indicators to understand your debt repayment capability. Why? Because in order to maintain a healthy credit score, you need to make timely and full repayments. Hence, a credit score is the most accurate indicator that signals whether you are falling into a debt trap.
Too Many Pre-existing Loans
Making too many loan repayments every month is another indication of a possible future debt trap. It’s not only exhausting but also increases your risk of defaulting. Moreover, you spend more than half of your income on paying interest rates on these loans, throwing savings out of the window.
EMIs Exceed 50% of Your Monthly Income
Today, it’s extremely easy to fall for attractive discounts on products and end up buying them on EMIs. Initially, you might think it’s not a big deal, but later, when you sit down to calculate your cost and budget, these EMIs become significant and leave you with nothing to spend on the important things. So, if your EMIs are exceeding 50% of your monthly income, it’s a sign that you might be in a debt trap.
Unable to Save Monthly
Whether it’s due to your fixed monthly expenses or debts, if you are not able to save money from your salary every month, it’s an early indication of falling into a debt trap.
Fixed Expenses Surpass 70% of Your Income
Apart from debts, other factors can also contribute to knocking you into a debt trap. These include fixed expenses you cannot neglect, like monthly rent, bills, school fees, etc. Make sure you work around your monthly financial budget in a way that you have enough to spend on your necessities and loans, and also have some to save for the future.
6 Ways to Get Out of a Debt Trap
If you have fallen into a debt trap or have spotted any of the above signs, here are some ways which can help you get out of it and even prevent you from falling into one in the future:
Evaluate Your Finances
Assessing your current debt situation is the first step to take in order to get out of a debt trap. Sit down and list out all the existing loans with their outstanding amount and interest rates. This will help determine which loans create a hole in your pocket the most.
Next, make a list of your necessary monthly expenses and calculate the total cost to understand how much you can practically afford to repay every month.
Prioritise Debt Repayments from Their Interest Rates
If you want to tackle one debt at a time, try to prioritise them by keeping the most expensive loan, which has the highest interest rates, at the top.
Budget Your Expenses
Next, start budgeting. Cut down unnecessary expenses. Control yourself from impulsively purchasing and step down from your current lifestyle. This is a crucial money-saving tip as it will reduce unwanted expenses, leaving more money to repay loans and creating a sense of financial discipline for the future.
Avoid More Debts
If you have already reached your maximum borrowing capacity, it’s time to stop taking more debt. Another thing to keep in mind is to maintain the debt-to-income ratio below 40%.
Consolidate Your Debts
Did you know that if you have too many loans to repay at different times in a month, you can consolidate them? Debt consolidation is when you combine all your loans into one new loan with a favourable tenure, interest rate, EMI, etc. So, instead of making separate payments multiple times to different lenders, you simply merge them into a single payment and lender with a lower interest rate. This method helps you pay your EMIs on time, save on interest rates, get your debt paid off faster, and regain financial stability soon.
Check Your Credit Score Frequently
As mentioned above, an excellent credit score indicates a healthy financial life. The better your scores are, the more choices you get in selecting the best lender with lower interest rates and the most comfortable loan terms. So, keep checking your credit score after every loan closure or once in three months.
Get a Professional Onboard!
If everything fails and you are not able to decide how to get out of debt, it is the best decision to seek professional advice from the experts. Financial advisory agencies can counsel you to make better financial decisions and help you set budget and expenditure limits.