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A debt trap is a situation in which a borrower is led into a cycle of re-borrowing, or rolling over, their loan payments because they are unable to afford the scheduled payments on the principal of a loan. These traps are usually caused by high-interest rates and short terms.
Causes of Debt Trap
Debt traps caused by credit card overspend happen because the ‘minimum due’ each month. You look at your bill of Rs1 lakh. Don’t have the money, and then you see the line that says you can just pay Rs5, 000 (5% of Rs1 lakh).
That much you can manage. And you make that minimum payment. What you don’t realize is that you just took a very, let us repeat that, very expensive loan. Why, it’s just 2-3% interest rate, you argue. What you don’t realize is that is just the monthly rate.
The industry average of annual interest rate on credit cards stands at 40.80% per annum. Remember your home loan, on which you bargained so much? It costs you an average of 9.5%. If you simply pay just the minimum on an Rs1 lakh credit card bill, you will end up paying Rs222, 602 over a 5-year period at a rate of 3% per month.
The debt trap is created when new loans are taken to repay older loans. The repayment of a loan has to come from income. The husband in the story was reluctant to ask his wife to find a job, as he worried that she would be upset with the loans they had. Both partners should be aware of all income, expense, and they must also make all money de decisions together.
Learning to live within means is not easy. Adopting a lifestyle that is in line with earnings, making sacrifices to ensure that debt is paid off, as a means to come back debt-free are all decisions that require determination. There are several instances of psychological damage that severe indebtedness can create, including depression and suicidal tendencies. It is important to take help before it is too late.
Deepening the crisis by borrowing more are not solutions. Debt incurred has to be repaid, and figuring how this can be done is what debt restructuring is about. Seek help before it is late.
Many banks have a debt restructuring and advice facility that helps chronic borrowers. There are also external agencies that can help. Seek professional help to see what is due, and how it can be reworked. Credit card dues can be converted into personal loans; penalties can be negotiated for waiver; repayment schedules can be structured in line with capability of the borrower.
Assets such as house, investments, provident fund balance and gold, can be pledged or mortgaged to raise money. Assets can also be sold to repay the loans. Many borrowers worry about saving face and social costs. With some help, they may be able to make decisions that have short-term costs but long-term benefits.
How to avoid Debt Trap?
You know you are in trouble if you begin to rotate your credit card debt between cards. You know you are in trouble when you begin to wake up from the stress of not having the money to pay off your debts.
You know you are in trouble when newspaper reports of a suicide due to debts makes you begin to panic. Use the panic monster to do a hard talk with yourself.
If you are in this trap, cut down on anything other than basic survival spends and start a program to pay back your debt. Break your fixed deposits and other savings to pay back as much of your credit card debt as you can.
Know your Good loans from Bad ones
Home loan is considered a good loan mainly because it’s a good value addition in the form of an asset. If you do not own a home and want to buy a home anytime is a good time as long as you can afford the EMIs. Home loan creates an asset and a back of the envelop calculation will show that the value of a real estate has been increasing in India for last 50 years. That means even if you decide to sell your house in the future, you would get more than what you paid for it. Even though the real estate market has been subdued in the recent past, there is no bubble in the making and prices of home are only expected to rise in the near future. If you have the eligibility and would want to own a house, do not hesitate from seeking a loan. Ensure you’re your EMI is limited to about 45 % or your monthly income and a home loan would do a lot of good in terms of creating a tangible wealth.
Loans that are required to fund your expansion or take care of working capital requirements are considered as a good loan. Cash should not be a constraint for growing and sustaining your business. A business loan can be needed for purchasing equipment, adding working space, marketing initiatives, fund acquisitions, refurbishment and even as working capital among many others. Unless your business is distressed, in which case a business loan may add to your problem, the cost of raising a loan for business is generally lower with moderate interest rates. This type of loan is considered good because it helps you to further the growth of your company, which in turn creates more wealth for the company and you.
Educational loans do not create any tangible benefits and hence often overlooked by people as a good loan. However, education loan is a very good loan to have as it creates an asset far superior to any house or business. The human asset is most valuable and a well-educated individual has the opportunity to do well and secure his future. Rest assured that the value of knowledge and wisdom will never diminish and education loan helps a person became a better human being. These loans also have lower interest rates and repayment structure is geared towards helping a student successfully repay it.
Personal loan for Holiday
Personal loans have some of the highest interest rate, second only to credit cards and hence should be taken only when absolutely necessary. Special occasions like marriage or unforeseen situations like bad health may warrant a personal loan, which is acceptable. However, people should refrain from taking a personal loan for a holiday as 5-7 days of holiday and paying EMI for 3-4 years is not a good idea. With interest rates ranging between 14-28%, personal loan for a holiday does not create any wealth or any asset for the future. Holidays are a welcome break from the everyday life and do enrich and broaden perspective, but should not be done at the behest of paying exorbitant interests. Save and then go for holiday, rather than taking a loan.
Many do not even realize that spends on Credit Cards counts as loans. While using your credit card is not bad if you can payback the entire amount due within the stipulated time, problems occur when you cannot do so or only pay the minimum amount due. Credit cards also make sense when one wants to avail the benefits of schemes like cash back and other promotional discounts. Interest on credit cards range between 40-60 % per annum and if you are not careful, there is every chance of falling into a debt trap. Cards give about 45 days free credit period and if you shop and pay via credit card, ensure you have the entire amount to pay at the end of the billing cycle. Outstanding that is carried from one billing cycle to the other can become very difficult to payback and every new spend on the credit card starts putting additional burden. This would be akin to taking a loan to buy a shirt or having dinner.
Auto loans are somewhat of a gray area. Some consider auto loans as good loans, stating examples where cars, trucks and vans are businesses itself. An example of this would be someone in the logistics business. For the general public, a car loan is still a bad loan because the value of your car decreases as soon as you drive it out of the showroom for the first time. It value only keeps decreasing over time and does not build and wealth. A car may be great for its utility, but realize it will not make any money for you.