What is Debt Trap and How to Avoid It?

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Debt is the amount of money due, to others, which might be a loan from a bank, a private lender, or money borrowed from friends and family. Nobody wants to be in debt, yet it is sometimes unavoidable. And getting into debt isn't always a terrible thing. When you take a medical emergency loan or to purchase a home or automobile, it is worthwhile since you will eventually own that item. However, there are many additional loans that are not worth it and might become a trap for you if your circumstances deteriorate.

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When Does Debt Become a Trap?

The reason loans become debt traps is because repaying some debts becomes a never-ending process since whatever you spend in repayment as EMIs are interest-heavy in early years and the principal amount is not lowered, making it a never-ending process.

There are two trustworthy signs of a debt trap:

1. EMI-to-Salary Ratio
   If your EMI is ₹10,000 and your take-home pay is ₹20,000, your EMI-salary ratio is 0.5. Experts recommend that this ratio be less than 0.3.
2. Loan-to-Asset ratio
   If your loan debt is 25 lakh and your equity is 10 lakhs, your loan-to-asset ratio is 2.5. This ratio should be less than 0.5, according to experts.

You might quickly slip into a debt trap if you do not take actions to boost your income, lower your loan amount, or build your assets.

What Causes Debt Trap?

There can be multiple reasons for why one falls into a debt trap. Let's discuss a few:

1. Your EMIs exceeds 50% of your salary
   Many people have become compulsive spenders because of accessible credit. They are readily swayed by discounts, deals, and the like, and end up purchasing items on EMIs. These EMIs may not be considerable on their own, but when coupled together, they can be significant, leaving less money to spend on other vital things. If your entire EMI amount exceeds 50% of your income, it's a warning sign that you're on your way to being a victim of a debt trap.
2. Your fixed costs account for more than 70% of your earnings
   EMI is not the only financial commitment you must meet each month; you must also meet other fixed expenditures. Rent, school fees, and utility bills are examples of these costs. Your fixed financial obligations-to-income ratio should ideally be less than 50%; if it surpasses 70% of your income, it's a warning indication that you're progressively falling into a debt trap. According to experts, you need at least 30% of your salary for other costs and to fulfil your financial goals.
3. Your credit card limit has been reached
   It's so simple to acquire products just swiping your credit card - get what you want without bothering about advance payment. However, if you've reached the limit on your credit cards, it's important to halt and reconsider your financial situation - you might be in a debt trap.
4. You have an excessive number of loans
   If you repay too many loans at different periods of the month, you may not only become exhausted, but you may also put yourself at danger of default. Furthermore, by paying interest on so many loans, you may be losing a lot of money.
5. You cannot afford to set money away for savings
   If you are unable to save money each month, it might be due to debt or other fixed obligations. This is one another clue that you are in debt.
6. Your loan application has been denied
   If your personal loan application was denied, it is the ultimate evidence that you are in debt. Banks and financial organizations review your credit record before authorizing a loan to determine your creditworthiness. Banks will not grant you extra credit if you are deeply in debt and lack the financial potential to repay another loan. Even if they do, it will be at a considerably higher interest rate, perhaps trapping you in a vicious loop.

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How to Come Out of the Debt Trap?

1. Determine the problem and analyse it: A detailed and meticulous review can provide you with the answer to your existing debt situation.
2. Make a budget and prioritise your needs: After a thorough analysis of your debt situation, you may now be able to identify essential, semi-essential and non-essential expenses.
3. Automate the payments: Repaying your loan in EMIs is the financial commitment you make with your lender. Automating your payments can ensure that you do not break this promise.
4. Avoid taking on more debt: While you've already borrowed to the hilt, avoid borrowing more. Make it a rule to keep your debt-to-income ratio, not more than 40%.
5. Look for ways to increase your income: One of the ways to get out of debt is to increase your income. The extra income can be used to pay off your debt faster.
6. Pay off the expensive loans first: If you are not considering debt consolidation and want to pay your debts separately (tackling one debt at a time), create a plan to pay off the most expensive loan first.
7. Get professional help: If you find it difficult or almost impossible to get out of the debt trap on your own, it is best to consult an expert.

Debts are beneficial if their aim is justified. All loans are not without merit. A person who lives a financially disciplined life will never go into debt and will instead make the most of any debts they take out. Spending on desires always appears more acceptable than saving for necessities to the ordinary Joe! This is what has kept Joe ordinary his whole life. Loans are not a laughing matter and should never be handled as such. Loans are intended to be used for specified purposes and repaid as quickly as feasible. Becoming lifelong friends with loans is virtually never a good idea.

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Disclaimer: Information shared here is for educational purposes only and should not be considered financial advice. Please verify independently and consult a qualified professional before making financial decisions.