What is Debt Trap?

Key Highlights

• The debt trap is a situation where you've been forced to take on more borrowings in order to pay off your existing debts.
• Eventually, you're stuck in a situation where the debt spirals out of control and exceeds your capacity to pay it off.
• As an example, the income you're generating isn't enough to get rid of your debt; interest on that outstanding loan level is going to be increasing rapidly.
• In the end, you'll be in a debt trap and will take out new loans to pay off that pile of interest.

Understanding Debt Trap Meaning

Debt traps are situations where a borrower is required to borrow more in order to pay off previous loans. Basically, a debt trap exists when the person's credit capacity is outweighed by an obligation to pay it back.

When you are compelled to take out additional loans in order to pay off your current debt commitments, a debt trap may arise, leading to a cycle of accumulating debt. If you can't pay it back on time or in full, even a small new loan can put you in a debt trap.

How Does a Debt Trap Work?

When you take out a loan from a moneylender, two things are involved: the interest rate (the amount the lender charges on the primary loan amount) and the main sum of the loan (the amount you borrow). Can you begin to pay off your loan when the principal begins to decrease? However, you contribute to both the principal and interest on your loan each month that you pay it back. This is because most loans have an amortising structure.

This indicates that the principal and interest on your loan are both applied to each payment you make and that the loan is meant to be repaid over a particular number of regular installments. You're most likely going to be in a debt trap if you don't make the payment, as if your loan won't be able to be paid because the principal hasn't decreased and interest will continue to rise.

Causes of Debt Trap

Let's take a look at some of the reasons that caused this debt trap.

1. EMIs are more than 50% of your income

Excessive spending can strain your budget, which could trigger a debt trap for you. You're more likely to fall into debt traps when you become an impulsive buyer and get caught up in EMI schemes or discounts. Before you buy something impulsively, it is important to keep your finances in mind.

2. Exhausting Credit Limit

Debt on credit cards is a simple way to get into a debt trap, as the exciting offers draw most people in and become involved with neverending credit card bills. However, credit card companies are charging a significant interest rate ranging between 16 and 32% per year.

3. No Repayment Plan

Credit cards or loans might tempt you, but you have to figure out a repayment plan first. It is useful to prepare a better repayment strategy by making use of an EMI calculator before applying for a loan.

4. Fixed costs are higher than your income

Today, the product market encourages people to ask for things they don't really need. In addition, a great many banks are prepared to provide you with just the minimum documentation needed for your loan. People can easily spend more than they earn because of this. This could be another reason for a debt trap if your regular costs exceed your income. Such a situation might arise if one borrows too much at the same time.

Indicators of Debt Trap

The indicators of a debt trap are as follows.

1. EMI Salary Ratio

The monthly loan payback amount and the monthly income of an individual are compared using a financial indicator called the EMI salary ratio. This ratio helps determine whether an individual is able to take on new loans while keeping his current expenses under control.

2. Lack of financial training

People may be more at risk of falling into debt because they do not know how to efficiently manage their money due to a lack of financial education.

3. The levels of personal debt are high

A high level of personal debt, in particular unsecured debt such as credit cards and personal loans, can indicate that individuals are living beyond their means and may be at risk of falling into a debt trap.

How to Avoid Falling into a Debt Trap?

Here are a few ideas to help you escape from the impending debt trap.

1. Check your priorities.

Some people tend to overspend without taking a good look at their expenses and patterns of expenditure. To avoid this, a list of priorities must be established in order to separate your needs. Divide the needs you have into three categories, essential, semi-essential, and non-essential. Make sure you focus only on the essential things.

2. An insurance policy to keep you safe

Obtain enough insurance to protect you and your loved ones from unforeseen circumstances. You may use all of your savings towards paying off your debt if you have insurance, as you won't have to worry about rising medical expenses.

3. Automate your bills for EMIs and utilities

You can authorize a bank or concerned organization to automate your EMI and utility bill payments. These invoices must be paid on time, without delay. This problem can be addressed by a system that automatically collects payments for such bills.

Conclusion

Most of us borrowed money when we needed it, but poor management of funds could lead to a debt trap. To prevent falling into the trap of debt, you can track your income and expenditures to find out how much money is being used. You can also make investment in stock market, which has low risk ratio, and accordingly diversify your investment ana have a backup for the financial crisis.