6 mins read . 02 Feb 2023
What do we understand by a debt trap? It can either be total debt levels that hamper your credit standing or debt of a level where current inflows are insufficient to service the interest and principal. The sad part of the debt trap is that you don’t realize it until you are neck deep into it. Let us look at it prophylactically rather than therapeutically. The question is not how to get out of a debt trap. The point is how to avoid falling into a debt trap. A few simple steps can help you stay away from a debt trap.
What is the best way to use an intermittent cash flow like a surprising capital gain or a bonus payout by your company? Possibly, your kind aunt left you a piece of land, that is today worth its weight in gold. What do you do with these intermittent cash flows? You would typically buy another asset or a consumer durable or get a swanky iPhone or even splurge on a holiday. Here is a smarter way; repay high-cost loans. Your credit card costs you 40% per year and your personal loan costs you 18%. When you repay these loans it is tantamount to earning such returns on your money. That is surely a smart deal!
Converting credit card dues into EMIs, rolling over by paying just 5% make a lot of sense to your banker, not to you. Don’t fall for such traps. Each month you are charged 3% interest which means you effectively reduce your outstanding by just 2% each month. If you miss even a single credit card payment then there is penal interest can be oppressive. You normally slip into a debt trap when you use your plastic too freely and then become lax in dealing with your outstanding credit card debt. Rolling over credit is a bad idea.
We get into a debt trap because we love to splurge on conspicuous consumption. You can occasionally pamper yourself but don’t go overboard with your plastic. It cannot be at the cost of your financial stability. For instance, eating out twice a month is understandable but eating out thrice a week is bad for your finances and for your health. If you can keep your conspicuous consumption within limits, it can be a big factor in ensuring that you don’t get into a debt trap.
In an age of easy credit and digital loans, you are bound to get a loan for every need. The problem is that you have to service these loans and that can add up to quite a bit. Don’t add loans just because the bank offers it to you. Too many loans with different maturities can be confusing and intimidating. One good way is to consolidate these loans into a single loan or a couple of loans with longer maturity. The EMI may be higher on a longer tenure, but your current cash flows are better managed. Always remember to negotiate interest rates and service charges. Every charge in the financial world is negotiable, you just need to persist.
What do we mean by negative equity? We often take loans against our property or our equity shareholding. There is a risk if the prices of these assets fall below a threshold. Then the bank asks you to bring in the additional margin or sell your assets. That is where the problem comes in so keep a close tab on asset values and if the value is falling then opt to partially repay the loan to reduce your burden. Always remember to borrow only as much as you require and not as much as you are eligible to borrow.
This is an important discipline that most of the borrowers should cultivate. For example, your total debt can be 2.5 times your assets if it includes a home loan, otherwise don’t cross 2 times. Ensure that the total of all your EMIs should not be more than 50% of your take-home salary. If you keep this discipline, it is unlikely you will get into a debt trap.