8 Warning Signs You are Falling into a Debt Trap

November 10, 2021 Mutual Fund

With innovations in finance and technology, borrowing money has become much easier nowadays than it was a few years ago. A few taps on the phone along with a quick online verification is all it takes to avail of a loan. Having said so, individuals, especially millennials, are getting allured by the easy access to credit, which is the primary reason for the lack of financial discipline among young adults. The reckless spending and lending can create a precarious situation of a debt overhang.

If you want to achieve certain goals along with taking advantage of tax benefits, you have to avail of certain loans. For example, a home loan and an education loan are essential loans. These loans are generally considered as ‘good loans’ because they actually help you in managing your financial requirements. However, availing of personal loans and excessive use of credit cards and credit apps are considered ‘bad loans’ as they can create a debt burden that you might struggle to pay.

What is a Debt Trap?

A debt trap is a situation when you are constantly in a cash crunch and are forced to take new loans to manage your expenses, existing loan or credit card dues. If you are in a debt trap you owe multiple dues to multiple or single lender/s that creates a financial burden on you. The situation mainly arises due to over splurging and binge lending.

What are the 8 signs that you are falling into a debt trap?

Here are the 8 warning signs that you are falling into a debt trap:

1. You borrow for regular expenses:

   If you often borrow money through personal loans, credit card loans, small amount loans from fintech apps, etc. and swipe your credit card for regular purchases, it is a sign that you are falling into a debt trap. Taking loans for regular expenses, such as school fees, house rent, purchase of groceries and clothing, etc. means you are in a cash crunch and are unable to meet your regular expenses. The only thing that can help in such situations is cutting down your unnecessary expenses and stopping the credit purchases. If you keep borrowing money for your regular expenses, you will get habituated with binge lending, which in turn leads to a debt trap.

2. Your EMIs exceed 50% of your monthly income:

   Many individuals tend to have multiple types of loans. As discussed, we cannot avoid taking 'good loans' as in many cases they are necessary. But, many individuals keep on borrowing every now and then for all their purchases, which is not a sign of a good financial health. As per most finance experts, your total Economic Monthly Instalments (EMIs) should not exceed 50% of your monthly income. If your total EMIs, including home loans, car loans, personal loans, credit card loans, credit card EMIs, exceed this limit, you need to take this sign seriously and stick to financial discipline to avoid falling into a debt trap. Although there is no fixed ratio that can tell if you are under a debt trap, many experts say that you are in a debt trap if your total EMIs exceed 70% of your monthly income. If you are already in a debt trap or falling into it, you need to avoid availing of bad loans, such as consumer durable loans, personal loans, credit card loans, etc.

3. You have no sufficient savings:

   For financial security, one must have sufficient savings and investments in diversified financial instruments. You should have a sufficient amount in your emergency funds, retirement funds, children's education funds, etc. to help you at different life stages. Moreover, it is equally important to have sufficient coverage of health insurance and term life insurance to financially protect your family's future. To achieve this, it is necessary to be financially disciplined and spend wisely so that you can save enough for a better future. This also means that your fixed expenses like EMIs, rent, school fees, etc. are more than 70% to 80% of your income. Not having sufficient savings is usually the first step of financial indiscipline that can lead to a debt trap.

4. You take a new loan to repay your existing loan:

   Having to take a new loan to repay your existing loan EMIs is one of the major signs that you are falling into a debt trap. Taking a debt consolidation loan or doing a Balance Transfer (BT) to save the interest outgo are common practices. However, if you have to take a new loan because you are struggling to pay the EMIs of your existing loans, you need to be careful as it is a sign of falling into a debt trap. After a few months, you will again struggle to repay the new loan and you will have to borrow more money. This cycle continues and at one point it becomes impossible to get out of the trap. Therefore, it is essential to stop taking unaffordable new loans from the initial stage.

5. You are unable to pay your credit card bills in full:

   Most people who fall into a debt trap have a common habit of using their credit cards excessively. If you use your credit card to the full capacity and then when you realise that you cannot pay it in full, you either pay the minimum amount due or convert the purchases into EMIs. Although these options seem affordable, you actually pay a lot more than the original bill. The rate of interest and processing fee for credit card EMIs are very high. Even though the credit card providers allow you to pay the minimum amount, they charge you heavy interest for the balance amount. Therefore, it is advisable to use your credit card only for emergencies or for the amount you can easily afford to repay.

6. You get cash against credit card:

   Cash withdrawal from a credit card or availing of a loan on your credit card attracts heavy charges. The cash withdrawal charges can range anywhere from 20% p.a. to 40% p.a. of the amount you have withdrawn. And, the rate of interest on credit card loans are usually between 15% p.a. to 30% p.a. Since these options of borrowing are amongst the costliest borrowing options, they can fall you into a debt trap in no time.

   Borrowing money through credit apps of Fintech companies is a similar option that offers instant funds without any security. These apps do not charge heavy fees initially but as you keep borrowing every month, the charges become higher. It is not advisable to use credit apps for any needs as they are addictive and you will fall into a debt trap without even realising it.

7. You are defaulting on your repayments:

   You miss your EMIs and credit card dues when you are running out of cash and cannot afford to pay your fixed expenses. Not paying the EMIs and credit card dues on time is another sign that you are falling into a debt trap. Missing timely repayments can create more debt as you will be charged late payment fees and high interest on it. With the additional interest and charges, the next repayment becomes even more difficult to pay. In such cases, people tend to avail of a new loan to repay the existing debt and fall into a debt trap. Furthermore, it can also negatively impact your credit score.

8. Your loan applications get rejected:

   When you have too many loans to repay and have utilised credit cards to their full capacity, your credit score can get affected by it, which is a primary reason for loan application rejection. Furthermore, there are many other reasons for loan rejection, such as not paying the credit card bills in full, defaulting on the EMIs, applying for multiple loans in a short duration, etc. that negatively impact your credit score. Once your credit score is affected, the lenders reject your loan applications. This is a final warning sign that you are falling or have already fallen into a debt trap. To avoid this, you need to ensure that you maintain or improve your credit score.

To Conclude:

Know the above mentioned early signs of falling into a debt trap to make necessary corrections at the right time. Financially literate and disciplined individuals make wise choices and never fall into debt traps. Therefore, it is advisable to improve your financial knowledge and control your temptations to splurge on credit. If you want to experience the luxuries and buy expensive items, start saving and use your savings to finance your splurging. Personal Loans and credit cards are supposed to be used only for emergencies. If you are getting better deals on shopping through a credit card, make repayment instantly. It is not advisable to use credit apps for day to day needs as such apps can be addictive, and you will create an enormous debt out of your small purchases in no time. Controlling and avoiding the use of credit facilities is the basis of financial discipline.

However, with the above signs, if you think you are falling into a debt trap, this article will help you lower your debt burden.

This article first appeared on PersonalFN here