What Is Debt Consolidation And How To Use It As A Tool To Come Out Of A Debt Trap?

Debt Consolidation

The Indian economy has opened up entirely with the market forces deciding the interest rates banks charge on their loans. At the same time, these forces also determine the interest rate at which the banks pay on your deposits. Today, it has become a transparent structure, enabling everyone to know and understand how the financial trends move. This opening up of the interest regime is beneficial in various ways. The most exciting advantage is the opportunity to adopt debt consolidation and use it as a tool to come out of a debt trap.

This article dwells on this topic, but before proceeding, let us clarify the debt consolidation concept and understand what a debt trap is.

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What is a debt trap?

Now, what is your prime responsibility when you take a loan? You agree that your main objective should be to repay the loan. Therefore, there should not be a problem if you can do it from your individual sources. But what if you cannot? There are two alternatives left for you. One is that you default on the loan repayment. Secondly, you take another loan to clear the existing loan. Surprisingly, the second option is more dangerous.

The first option pushes you into default, but the second option takes you into a debt trap. Thus, we define a debt trap as a situation when you take a loan to repay an existing loan liability.

For example, you have to repay the home loan installment that is becoming due this month. You do not have money. So, you swipe your credit card and take a card advance to pay your home loan installment. It should not be a problem if it is a temporary arrangement. But, it can assume dangerous proportions if it becomes a regular occurrence. Please note that you are taking a loan at 36% per annum to repay a loan installment where the interest rate is 7% per annum. Under such circumstances, you are reducing your home loan liability while increasing your credit card liability. So, a possible solution to such a situation is to go for debt consolidation.

What is Debt Consolidation?

debt consolidation.

The name Debt Consolidation itself is suggestive. You consolidate all your loan liabilities in a single place, making it easy for you to repay your installments.

Here is a debt consolidation example.

Suppose you have the following loan liabilities.
  1. Home loan at Bank A – Outstanding Rs 18 lakhs @ 7% per annum, with EMI of Rs 20,000 per month
  2. Personal loan at Bank B – Outstanding Rs 3 lakhs @ 10.50% per annum, with EMI of Rs 8500 per month
  3. Personal loan at Bank C – Outstanding Rs 2 lakhs @ 11% per annum, with EMI of Rs 7500 per month
So, your monthly loan liabilities are Rs 36000. However, your income levels are Rs 50000, making it challenging to repay the installments. Such a situation can take you into a debt trap. Meanwhile, Bank D offers a home loan takeover proposal plus a top up facility totaling Rs 23 lakhs @ 7% per annum. In addition, the bank stipulates an EMI of Rs 26000 per month. What would you do? Solution – You should jump at the offer and take it immediately for the following reasons.
  1. You consolidate all your loan liabilities in a single place, Bank D. As a result, you have to pay a single EMI of Rs 26,000 instead of three different installments totaling Rs 36,000.
  2. Your disposable income increases by Rs 10,000, making it easy to pay the installments and avoid entering into a debt trap.
  3. You shift from a higher interest loan to a lower interest facility.
Thus, debt consolidation can benefit you and rescue you from a debt trap. Today, many banks offer debt consolidation facilities to their customers and even new clients. However, you should not blindly go for debt consolidation without considering certain crucial aspects.
  1. Your overall debt position should preferably not change. Otherwise, you could again end up in a debt trap.
  2. The total tenure of the new debt should preferably not exceed the existing debt. Otherwise, you keep paying your debts for extended periods and pay more than you would have otherwise done initially.
  3. The interest rate on the new loan should be less than that you pay today.

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Final Thoughts

Debt consolidation is the ideal solution to avoid falling into a debt trap. So, now you know what a debt trap is. Therefore, we advise you to weigh your income and liabilities to know whether to go for debt consolidation.