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By Alpha Research
Aug 08, 2022
Debts and bankruptcy! The words sound painful, and they are dreadful topics as well. But, although economies run on the foundations of value creation and debt, those who had to shoulder the burden of debts know how it eats away one’s financial resources.
To understand the debt trap, we can look at the hypothetical situation of Mr. Sharath. He was thrilled when his first credit card arrived at his doorstep. The credit limit of his card was ₹1,00,000. He thought his monthly expenses would be covered by a fraction of this credit limit, and he had tons of money left to buy things he never could. These thoughts led him to go on a shopping spree by paying the Minimum Amount Due (MAD) every month.
Sharath’s reckless spending continued for a few months, and the interest on the credit card payments kept accumulating. Sharath did not pay much heed to that, and little did he know how much would be the amount after interests.
After nearly six months, he was buried neck deep in debt.
Sharath’s story is hypothetical, but this happens to 50% of the credit card holders in our country. The debt trap cycle feeds on itself and grows bigger if the debtor does not do anything about it.
This article tries to educate you about this financial trap and shows you how to get out of it.
Understanding Debt Trap
The debt trap is something similar to falling in love. It seems like an absurd analogy, but it will do justice to the topic. One never realizes when he or she is falling in love, and when one does, he or she is neck deep into it. One may try to get out of it upon realization, but by that time, it becomes challenging and painful to get out of it.
In a debt trap, you get stuck in a cycle in which you are burdened by debt with compound interest adding to it over time. You might be compelled to take other loans to repay the existing loan, ending up paying the interest on both loans.
Over time, this credit cycle spirals out of control until you fall short of your repayment capacity and get stuck with no way to escape.
The Debt Trap Mechanism
In short, a debt trap is a situation where you take new credits to service your existing debt obligations. In such a situation, your debt obligations exceed your repayment capacity.
Look at the example of Mr. Sharma to get the concept clear.
Sharma’s daughter dreamed of a lavish wedding beyond his financial resources. But yielding to his daughter’s unswerving wish and demands, Sharma had to take a personal loan with a 13% interest rate.
Unfortunately, after retirement, Sharma couldn’t afford his expenses and the Equated Monthly Instalments (EMI) of the loan with his meager pension. Soon he began to default on EMIs. The defaulted EMIs invited more interest, and his debt obligation kept compounding.
When Sharma noticed the compound interest being added to his loan, he made a wrong decision: he borrowed money from his cousin at an 11% interest rate. So now, he is liable to pay the interests on two debt obligations for years.
A Few Major Triggers of Debt Trap
Here we point out some significant triggers or causes that could put one in a debt trap.
We are living in a consumer society influenced by advertisements and promotions. Today, the marketing of consumer products has reached new peaks. All these have led us to follow the trends and impulsively buy things we don’t really need.
This impulsive buying out of Fear of Missing Out (FOMO) causes unnecessary expenses that stretch out of most of our budgets. People naturally rely on credit, such as personal loans, car loans, and home loans, to meet these expenses. This could add an EMI burden to the existing loans.
No one can evade some monthly fixed expenses like rent, utility bills, fuel, and education fees. The ideal expenses to income ratio should not go beyond 50%.
The home loan, car loan, and personal loan add up to your expenses. More loans mean more interest that ultimately leads to more financial burdens, which become difficult to manage along with monthly fixed payments.
If there were the worst form of debt, it would be credit card debt. This is because the interest rates of credit card debts are higher than personal loans. To make matters worse, if you start to default on credit card payments, you will get stuck in a vicious cycle of paying compound interest repeatedly.
Saving and investing money is a simple concept, not rocket science, for wealth building. However, if a significant portion of your revenue is spent on servicing debts and fixed expenses, there would be no money left to save and invest, leaving you with no option for building your wealth.
Getting Out of Debt Trap
Now you understand what a debt trap is and the causes behind it. So here, let’s find out some ways to get out of it.
A Pinch of Financial Advice
Debts, loans, and credit are inevitable in financial planning and wealth building. There is no shame in seeking credit or loans. Always remember that poor financial planning and management bring financial distress or put you into a debt trap.
Contrary to popular notions, you don’t need to get into a debt trap to learn from it. Instead, you can learn from the experiences of others and try not to repeat the same mistakes.
Justin Raj
Alpha Research
