What is Debt Trap and 6 Ways to Avoid a Debt Trap

what is debt trap

What do most people do when they save money? They let go of something they desire today for the sake of a better lifestyle tomorrow. But today, with credit cards, EMI schemes, and loans, money is available at a click of a button, giving people the freedom to fulfil their desires as and when they occur.  

The easy availability of credit has made people very comfortable with the idea of taking on debt to meet their lifestyle demands. But this comfortability can sometimes make things go out of hand, and unfortunately, there are serious consequences to it. The most significant one is the debt trap.

What is a debt trap?

Technically, a debt trap is a situation where the amount of debt you owe spirals out of control. Such a situation arises when you spend more than you earn. But life happens. Unexpected events, a decision to pursue an education or bad planning can push you into taking on debt that may take years to pay off.

 

Common Causes of Debt

Let’s understand some of the main causes of debt. This will help you make better financial decisions and avoid debt.

  • Loss of income or low income
  • Education costs
  • Unexpected emergency
  • Extravagant lifestyle
  • Bad budgeting
  • Depending on credit cards
  • Little or no savings
  • Spending future money

How to Avoid a Debt Trap

Avoiding debt trap requires the right kind of financial planning and management. Here are six ways that can help you avoid debt traps.

  1. Identify the issue

    Analyse the situation you are in and identify the areas of concern. Create a plan to address the areas which are in your control. A detailed, meticulous review of your current situation could be your answer to your debt problems.

  2. Prioritise your needs

    After a thorough analysis:

    • Break down your expenses into essential, semi-essential and non-essential.
    • Segregate these expenses on the basis of priority.
    • Make behavioural or lifestyle changes to avoid spending on semi and non-essential items.
  3. Consider debt consolidation

    Debt consolidation allows you to take a single loan to pay off your different loans. Once you consolidate your debt, you just have to worry about repaying one loan instead of servicing different loans with varying rates of interest on different dates.

  4. Leverage your investments to repay debt

    If you’ve invested in high return schemes such as mutual funds, bank deposits, chit funds, or equity, you could use them to reduce your debt obligations. Once you’ve settled a considerable amount of debt, you can focus on rebuilding your wealth again.

  5. Stop taking on more debt

    Taking more loans to pay off your existing debt increases your financial obligations and adds financial and mental stress. So, avoid them altogether.

  6. Build an emergency fund

    It’s important to have a separate fund only to deal with financial emergencies. Ideally, an emergency fund has to be of at least 3 to 6 months of living expenses. This fund helps you to navigate through tough times without having to rely on a loan.

    You can park this money in various investment tools that assure high liquidity. Although a bank saving account is a good option to keep your emergency funds, it doesn’t give you good returns. You can consider parking your emergency fund in a chit fund that ensures quick liquidity and better returns.

Things to Evaluate Before Taking a Loan

A loan may give you immediate access to money, but there are several costs attached to it. Therefore, you must evaluate the offer before you take it. You should:

  • Remember to read the fine print thoroughly.
  • Check the total cost of borrowing money.
  • Explore all online and offline offers to get the best deal.
  • Consider various other costs associated with the loan or EMI scheme, such as pre-closure penalty, late payment fee, processing fees, etc.

Key Takeaway

Healthy control of your finances can go a long way in avoiding debt trap and achieving financial freedom. So, if you are using a loan or credit to buy things or solve pressing financial goals, repay it on time to safeguard yourself from high interest rates and debt traps.