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What is a Debt Trap: Here is How to Avoid It

July 18, 2023 • 1170 views

Today, the need for additional financial requirements can be solved by availing of different types of loans. There are various types of loans that can help you meet various financial requirements, such as Personal Loans, Professional Loans, Business Loans, etc. However, if you mismanage your debts, there is a high risk of falling into a debt trap from which you may find it impossible to get out. This blog provides steps on how you can avoid falling into a debt trap.

What is a Debt Trap?

A debt trap occurs when a borrower is forced to avail new loans just to pay off existing loan. It happens when the amount of debt becomes too much to handle based on one's ability to repay. When repaying a loan, there are two parts: the principal (the initial amount borrowed) and the interest (the additional cost of borrowing). These are paid off over a fixed period.

It is important to realise that a debt trap is not solely determined by the size of loan. Even a big loan can be manageable if the borrower's income is sufficient. The key factor is whether the borrower can make the EMIs on time. If payments are missed or delayed, the interest keeps adding up, increasing the overall debt. In such a situation, borrowers may find themselves taking out new loans to repay the old loans.

Even a small loan can lead to a debt trap if it cannot be repaid on time and the interest keeps adding each month. Other circumstances, like taking an expensive short-term loan to solve an immediate financial problem or experiencing an unexpected loss of income, can also contribute to falling into a debt trap.

Postponing debt repayment in the hopes of receiving more funds or defaulting on loan commitments due to unforeseen circumstances can further worsen the situation. Avoiding a debt trap is crucial as it has multiple negative consequences, including financial problems, damage to CIBIL score, along with emotional and social issues. Managing funds effectively and making timely repayments are essential to prevent getting trapped in a cycle of debt.

What are the Causes of the Debt Trap?

  • When EMIs Exceed Your Income: Due to the availability of easy financing, many people have developed a habit of spending compulsively. They are easily enticed by discounts, sales, and other offers, which leads them to make purchases on EMIs. Although each EMI may not seem like a large sum, when they add up, they can become a significant amount, leaving less money for essential expenses. If you notice that your total EMI payments exceed 50% of your income, it could be a warning sign.
  • Lack of Financial Education: Without sufficient financial education, people are at a higher risk of getting caught in a debt trap because they may lack the necessary knowledge to handle their finances wisely. For instance, if someone borrows money without fully comprehending the interest rates and repayment timelines, it can result in them being trapped in a cycle of debt.
  • Exhausted Credit Card Limit: Making purchases with a credit card is convenient, allowing you to buy what you want without immediate payment. However, if you reach the point where you have reached the maximum limit on your credit cards, it becomes essential to assess your financial situation. This circumstance may indicate that you are at risk of falling into a debt trap and need to carefully reconsider your overall financial standing.
  • Poor Debt-to-Income Ratio: If a significant portion of your monthly salary goes towards debt repayment, it can be a sign of financial strain. When debt payments consume a large proportion of your income, it becomes challenging to manage your finances effectively.

How to Protect Yourself from Debt Trap?

To protect yourself from falling into a debt trap, you need to identify the red flags in your financial situation. If you notice even one of the causes mentioned above, it is necessary to seek help immediately.

Another measure you can take to avoid getting into a debt trap is to have a budget. A monthly budget that accounts for your income and expenses ensures that you are spending within your means. Ensure that you allocate money for essential expenses like housing, utilities, and groceries, and reserve some for saving. By adhering to your budget, you can steer clear of excessive and unnecessary spending.

A Proven Solution to Come Out of Debt Trap

Although getting out of a debt trap might take time, it is completely doable. You can follow these procedures to fix the issue

  • Consolidate Your Debts: Debt consolidation can make it easier to manage your debt by combining all your loans into one. With this option, you will not have to worry about dealing with multiple loans that have varying interest rates and due dates. Also, you will be able to pay off your debts faster, enabling you to gain control over your finances.
  • Minimise Expenses: You can accelerate your debt repayment by reducing discretionary expenses. While eliminating all miscellaneous expenses at once may be challenging, aim to minimise them as much as possible to make progress toward paying off your debts more quickly.
  • Get Protection for Unforeseen Circumstances: Insurance is a crucial tool that protects you from unexpected situations that can bring financial hardship. Whether it is a natural disaster or personal setbacks like losing your job or facing disability from an accident, insurance plays a vital role in helping you meet your financial responsibilities during such challenging times. By having insurance coverage, you can prevent yourself from sinking further into debt and find stability in your financial journey.

Conclusion

In conclusion, you should be responsible while taking charges of your finances to avoid a debt trap and attain financial freedom. You should use loans for important financial objectives, but it is important to repay them promptly to protect yourself from steep interest rates and debt traps.

Frequently Asked Questions

  • What is the difference between debt and debt trap?

Debt is the borrowed money that needs to be repaid within a specified period while a debt trap occurs when a borrower struggles to repay multiple debts, leading to financial distress and difficulty in escaping the cycle.

  • What are the two factors responsible for the debt trap?

Below are the two factors responsible for the debt trap

  • High interest rates: When borrowers face high-interest rates on their loans, repayment becomes difficult. This can lead one into a debt trap.
  • Insufficient income: If borrowers have insufficient income to repay their debt, they may borrow more loans to pay off the existing debt, creating a cycle of increasing debt.

Disclaimer

We take utmost care to provide information based on internal data and reliable sources. However, this article and associated web pages provide generic information for reference purposes only. Readers must make an informed decision by reviewing the products offered and the terms and conditions. Loan disbursal is at the sole discretion of Poonawalla Fincorp.
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poonawalla fincorp team

Poonawalla Fincorp Team

Our team of expert writers and editors are passionate about providing authentic and valuable information on finance. Our aim is to simplify financial and finance-related concepts. We strive to help our readers become more aware and empowered to make informed financial decisions.

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