What is a debt trap, and how can it be avoided?

The dictionary defines the term ‘trap’ as a set-up to lure someone in. It typically has an easy entry point, but the exit is far out of reach, if not absent. A debt trap operates in a similar manner. The entry may be enticing and seemingly convenient, thanks to easy and quick access to money with low to no formalities. The exit, however, could be elusive, endangering one’s financial peace and stability.

In this article, we will learn about a debt trap and how to tackle it.

Understanding debt trap meaning, examples, causes and more

What is the debt trap cycle?

A debt trap is a cycle that could begin as soon as you take your first loan or credit facility. What may seem like a convenient financial solution initially, may spiral into a financial burden in no time. The trap begins to tighten when your financial responsibilities become overwhelming, weakening your ability to repay. The resultant financial distress pushes you to seek additional monetary assistance, which only accelerates the vicious cycle. New loans, interest and penalties become a nurturing ground for an inescapable debt trap.

What are some of the indicators or examples of a debt trap?

While the debt trap indicators can be subjective, here are some common warning signs to look for:

1. A large part of your monthly salary goes toward your monthly expenses 

According to experts, a monthly Equated Monthly Instalment (EMI) obligation of more than 50% of your monthly income or fixed expenses of more than 70% is alarming and one of the biggest warning signs of an approaching debt trap. An unhealthy expense-to-income ratio underlines your inability to manage your day-to-day expenses well and save money, which is essential for steering clear of debt in the future.

2. You have debt multiple credit cards 

Multiple credit cards indicate a lack of financial literacy. The seemingly low monthly interest rates of 2.5% to 3% can quickly escalate to an Annual Percentage Rate (APR) of 35% to 43% because of daily compounding, especially if you do not make timely repayments and keep carrying your balance forward. Moreover, these postpaid cards create a false sense of greater spending power, when actually, it is quite the opposite. As a result, you keep increasing your card bills and moving toward the debt trap.

3. You do not clear your dues wisely 

Paying only minimum credit dues or frequently missing repayments highlights your financial uncertainty. Making only minimum repayments barely reduces your principal amount. In most cases, it only covers the interest or fees, causing the original debt to remain the same or even grow further. Missed repayments also invite unwanted fees and charges, in addition to increasing debt.

4. Relying heavily on credit for day-to-day needs

While a little credit occasionally does no harm if planned well, overdependence is bound to push you deep into the debt trap. If you are resorting to debt to meet your regular expenses, such as monthly groceries or rent, you must relook your finances and take corrective actions before it is too late. Expenses will never end, but your reliance on credit must end if you want to avoid crumbling under a debt burden.

What are the causes of a debt trap? 

Here are some reasons people get stuck in a debt trap:

1. Lack of financial planning

An important part of financial planning, budgeting is often an underestimated tool. If you have a monthly budget, you will have all your big and small expenses meticulously planned, then you are unlikely to encounter devastating financial shocks. The absence of a budget makes you underestimate your expenses and overspend. This also leads to neglecting savings for your goals and even emergencies. The lack of money ultimately forces you to resort to debt and enter the loan trap.

2. Easy availability of credit

Earlier, the complexity of getting credit would deter people from taking formal loans. They would instead turn to their friends or family for help, which was less financially detrimental. However, the easy and quick availability of loans today, with money reflected in the bank account within a few minutes, has made people close their eyes to the reality of debt.

3. Unstable or irregular income

Low income or irregular income is also one of the reasons people are desperate to seek credit. This sometimes drives them towards the repercussions of excessive borrowing. The hasty and unthoughtful financial decisions to bridge paycheck gaps regularly lead to long-term debt.

4. Lack of financial literacy

Financial literacy opens eyes to the long-term damage that excessive debt can cause. Unless you understand how interest rates work or the hidden terms behind alluring offers, you may fall into a debt trap.

5. Peer pressure

Peer pressure is often one of the leading causes of a debt trap. You may have enough to sustain your lifestyle but not enough to match that of your peers. This disparity can cloud your judgement and push you toward higher indebtedness. What may start as a one-time expense can silently turn into a huge financial burden over time without you even feeling the brunt midway.

How to avoid falling into the debt trap? 

You can have debts but still avoid getting stuck into the trap. Here’s how:

1. Prioritise budgeting

A budget is a powerful tool that allows you to take control of your finances instead of being controlled by them. With an overview of your income and expenses, you will live within your means, tend to spend cautiously and save more diligently.

2. Create an emergency fund

An emergency becomes your financial strength during difficult times. It helps you face any financial blows without resorting to debt or draining your savings. Ideally, you must have an emergency fund adequate enough to help you meet three to six months of expenses comfortably.

3. Look for ways to generate extra income

The more money you have, the faster you can repay debts or secure your financial future. You can look for side jobs to add another source of income or grow your skillset to justify higher pay. Moreover, you can also start investing your money to amplify your wealth.

4. Prioritising repaying existing debt

With a proper budget, emergency fund and additional income, you are better equipped to repay debts faster. You can follow the avalanche method to pay off the highest-interest debt first or the snowball method to start paying off small debts to gain momentum. Alternatively, you can also consider a personal loan for debt consolidation.

How can a personal loan help come out of the debt trap?

Debt consolidation means turning multiple debts into a single debt, which can be a loan, a balance transfer, or a line of credit, among others. This conversion is primarily done to take advantage of lower interest rates but also eases and quickens debt management.

Picture this: You have a total debt of Rs 1,00,000 with a 25% APR, and you repay it in three years. In this case, you will pay a total interest of Rs 43,135.37. Now, if you take a personal loan of Rs 1 lakh with a 13% interest rate and a three-year tenure, you will pay a total interest of Rs 21,298.23. The potential savings of almost Rs 22,000 explains why debt consolidation is so commonly used.

Debt consolidation is a systematic process that includes listing all debts, checking and bettering the credit score, researching lenders and understanding loan terms, applying for a suitable loan, paying off existing debts, and, most importantly, practising financial discipline to avoid new debts.