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What is a Debt Trap? How can we avoid it?

What is Debt Trap
Once upon a time lived a young entrepreneur named Rohan. Rohan aspired to start his own business and support his family. He worked hard, saved money, and eventually got a loan to start his business. However, things did not go as planned, and Rohan soon found himself struggling to make loan payments. The interest on his loan continued to rise, and Rohan soon realised he had fallen into a debt trap.
 
But there is a way to avoid it. By understanding the warning signs and taking proactive measures, individuals can protect themselves from falling into the debt trap and secure their financial future. In this article, we will explore the concept of the debt trap, its causes and consequences, and importantly, how you can avoid it.
 

What is a Debt Trap?

A debt trap is a situation where you take on more debt than you can handle and is unable to repay it. It often happens when you or your business entity takes a loan intending to use it for productive purposes but ends up spending more than you intended, or your financial situation worsens, leaving you unable to repay the debt.
 
Debt trap works through a combination of high interest rates, fees, and penalties, which make it increasingly difficult for the borrower to repay their debt. This leads to a cycle of borrowing more money to pay off the interest and fees on previous loans, trapping the borrower in a cycle of debt.
 
In some cases, debt traps are created deliberately by lenders. Such lenders offer loans with unfavorable terms and target vulnerable populations, such as low-income families or those with limited financial literacy.
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What are the Most Common Reasons for the Debt Trap?

  • Living beyond means

    People who spend more than they earn are more likely to fall into a debt trap. When they run out of money, they often turn to loans to pay their bills, creating a cycle of debt. Not only you but all generations here should always check their borrowing habits and always stay within the EMI 50% of their monthly income.

  • Unexpected expenses

    Unexpected events, such as a medical emergency or job loss, can quickly put a person in debt, forcing them to take out loans that they may not be able to repay. The most common instances of how job losses can trap one in a debt trap occur at the start of covid-19. To address this, the government offered a moratorium and a one-time debt restructuring solution.

  • Lack of financial literacy

    People who do not understand the terms of the loans they are taking out are more likely to fall into debt traps. They may not realise the high cost of borrowing or the long-term consequences of taking out loans. For example, you may have observed many people unnecessarily using credit cards on several luxurious items such as branded clothing, gadgets, or dining out in expensive restaurants. However, when the bill payment deadline arrives, the amount is far greater than what they earn. 

  • Predatory lending

    Predatory lenders take advantage of people in desperate need of money, offering loans with terms designed to trap the borrower in a cycle of debt. This lending is most common in rural India, where people still rely on money lenders to meet their financial needs.

  • Unaffordable loan payments

    If a person takes out a loan with payments that are too high for their budget, they may find themselves in debt. Given this, we always recommend using a loan EMI calculator to determine the best loan amount and payback period.

  • Unforeseen events

    Natural disasters, the death of a breadwinner, or other unforeseen events can result in a sudden change in financial circumstances, leading to a debt trap. To avoid passing the debt burden to loved ones, one should invest in loan insurance and term life insurance.
     

How to come out of the Debt Trap?

Getting out of debt can seem overwhelming, but it is possible with a plan and determination. Here are some tried and tested ways to help you get started:

  • Create a Budget

    Begin with budget preparation that tracks your income and expenses. It will help you see exactly how much money you have coming in and going out each month. Use this information to figure out the key areas where you can reduce your spending.

  • Prioritise Your Debts

    Make a list of all your debts, including credit cards, personal loans, and other outstanding bills. Rank them in order of priority, starting with the debt with the highest interest rate. It will help you focus on paying off the debt that costs you the most.

  • Make a Payment Plan

    Develop a plan to pay off your debts, starting with the debt with the highest interest rate. Make the minimum monthly payment on liabilities not affecting your creditworthiness, and use any extra money you have to pay down the debt with the highest interest rate.

  • Increase Your Income

    Consider ways to increase your income, such as taking on a part-time job or freelance work. This extra income can help you pay off your debts more quickly.

  • Avoid Taking on More Debt

    It is vital to avoid taking on more debt while you are trying to get out of debt. That means not using your credit cards and avoiding loans or financing deals.

  • Seek Professional Help

    If you are having trouble getting out of debt on your own, consider seeking professional help. This could mean working with a financial advisor or a credit counselling service. They can help you create a plan to get out of debt and provide support.
     

Consequences of Debt Trap

  • Your credit score can be negatively impacted, making it harder for you to secure loans in the future.
  • You may have to sell assets or cut back on essential spending to repay debts.
  • Interest charges on your debts can accumulate, making it harder to pay them off.
  • You may have to take on additional debt to pay off existing debt, leading to a vicious cycle of debt.
 
Also Read: Simple Steps to Effectively Manage a Debt Repayment
 

Conclusion

In conclusion, the debt trap is a scenario where you find yourself in a cycle of borrowing to repay existing debt, leading to a growing burden of debt and interest charges. It can have severe ramifications for your finances and well-being. However, you can avoid falling into the debt trap by making a budget, paying off debt as soon as possible, and avoiding high-interest loans. You can confidently achieve financial stability and pursue your dreams and aspirations by taking control of your finances and avoiding the debt trap.
 

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Did You Know

Disbursement

The act of paying out money for any kind of transaction is known as disbursement. From a lending perspective this usual implies the transfer of the loan amount to the borrower. It may cover paying to operate a business, dividend payments, cash outflow etc. So if disbursements are more than revenues, then cash flow of an entity is negative, and may indicate possible insolvency.

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