Educating Investors

What is a Debt Trap and ways to get out of it.4 min read

It is a situation in which borrowing is difficult to repay, typically because huge interest costs generally prevent the settlement of the principal amount. In the most lucid language, a debt trap would mean getting under the burden of debt and not able to find solutions to get out of debt and become debt-free. No business has become a billionaire without the help of leverage. Leverage is not a bad thing, but if not planned very well, one could get into the trap.

Whenever a person borrows money, he has to repay the principal amount along with interest charged by the lender. Repayment of principal essentially reduces the burden of debt on the borrower. In the times of crisis, the borrowing rates go substantially high, and the borrower, more often than not, is just able to repay the interest. At the time of maturity, the borrower fails to accumulate enough funds to repay the principal amount of the loan. To avoid the default, the borrower would enter into another loan transaction with some other lender to borrow money for a short duration. This borrowed money has no further use other than the repayment of the first loan. Since the tenure of the new loan is lesser, interest rates would be substantially higher. This cycle carries on until the borrower finally finds himself in the debt trap.

To summarize, debt trap is when the borrower looks for short term loans to repay its long term loan obligations i.e. Taking a loan to repay another loan is a typical case of falling into a debt trap.

Job layoffs/loss, delay in salary credit, medical emergency etc. could be some reasons for falling into a debt trap. Such emergencies can force an individual to borrow without a plan, beyond repayment capacities and at higher interest rates and thus forced to fall into a debt trap. The major problem is that the individual is overburdened by the debt slowly and gradually as it goes unnoticed mostly.

Prevalent indicators to look for to avoid getting into a debt trap are higher EMIs and fixed expenses to the total income, excessive use of credit card for regular daily expenses, borrowing short term loan to finance another loan etc.

Another most important factor is the element of compound interest in the loan. Most of the lender offer loans based on compound interest calculation only. Compounding is considered as the 8th wonder of the world, but compounding can work against consumers who have loans and debts. For most longer duration loans, the borrower ends up paying more interest than the principal because of the effect of compounding. Borrowers should be cautious while entering into a loan agreement and understand the terms thoroughly beforehand. 

Ways to get out of debt

  1. Pay more than the EMI / minimum due amount whenever there is surplus cash left for a given month. Such practise will allow the borrower to repay part of its principal as well.
  2. Debt Snowball Method: This method allows the borrower to get rid of the debt in a planned manner. The borrower will have to make a list of all the debts and arrange them in ascending order. The borrower shall pay the minimum balances of the larger loans and shall try to clear off the loans with the lesser outstanding balance. Once the borrower pays the loan with the least balance, he shall put that extra money towards the next lowest amount of debt and so on. Such practise will allow the investor to reduce the overall interest costs as well as create a positive psychological effect by these smaller wins.
  3. Create a tighter budget to cut down on unnecessary expenses and thereby, ending up saving more every month to use it to repay the outstanding debt’s principal amount. 
  4. Changing habits and lifestyle will always call for a reduction in the unwanted expenses, thus, remaining with a surplus for that given month. 
  5. Make lumpsum principal repayments – This will reduce the future cash outflows as well the tenure of the loan, thus helping to get debt-free sooner than expected.
  6. Burning the hands into a part-time job –  It might be challenging to cut down on necessary regular expenses. Therefore, one should look to increase the total income, thus increasing the amount saved monthly. 

To summarize, Individuals can avoid falling into a debt trap by following these simple steps;

  1. Create a short term budget regularly and review it at the end of the period.
  2. Don’t over leverage.
  3. Avoid the use of credit card for regular expenses
  4. Plan for future large cash outflows in advance.

The primary objective of leveraging is that the cost of leverage is less as well as it continues to boost the liquidity. The thought process is that the future income levels will pick up in months to come and thereby, help in repayment of these debt obligations. The only fundamental calculation that is required to be made is the repayment of debt. To avoid falling into a debt trap, an individual must have a budget in place to service the debt in the future. 

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