Debt Trap - Causes and How to Get Out of it?

A debt trap is a situation in which an individual or entity is overburdened by debt, making it increasingly difficult to repay the borrowed amount. This often leads to a debt cycle in which new loans are taken out to cover existing debts, causing the total debt burden to grow exponentially.

Anyone can fall into a debt trap, regardless of their financial situation, and due to various factors. Therefore, it is essential to manage your finances smartly to avoid such situations. Read this blog to understand the major causes that lead to debt trap and how one can come out of it.

Now that you have a brief understanding of what is debt trap, let us understand how one can land in a debt trap with an example:

Suppose you take out a ₹50,000 loan for medical expenses at 18% interest. After struggling with repayments, you take another ₹20,000 loan at 24% interest to repay the loan amount. However, due to the higher interest rates, you are finding it difficult to pay off both loans. 

This sets off a cycle where you keep borrowing more to settle old debts, creating a loop of debt that can be hard to break. This cycle of borrowing to repay existing debt is known as a debt trap.

The following are the two major indicators of a debt trap and should be considered to avoid falling into a debt trap:

• EMI-Salary Ratio

This ratio compares how much you pay each month towards loans to your monthly income. It helps you determine if you can take on a more loan while handling your current expenses. For instance, if your monthly EMI is ₹5,000 and your salary is ₹15,000, your EMI-Salary Ratio is 0.5. Experts suggest this ratio should ideally be below 0.3 to manage finances comfortably.

• Loan-Asset Ratio

This metric compares your total debt to the total value of your assets. A high ratio means a significant portion of your assets are funded by debt, which could pose financial risks if you struggle to repay. A lower ratio suggests less reliance on borrowed funds, indicating a healthier financial situation.

Both individuals and businesses can fall into debt traps for various reasons. If you have multiple loans or run a business, understanding the common causes can help you avoid struggling to repay your debts. Here are some common reasons for debt traps:

• Overspending

If you often overspend, you may need to borrow money to maintain your lifestyle. This is risky, as loans should be used for emergencies or major life goals.

• Using High-Interest Credit Options

High-interest credit options, like credit cards, can be useful if managed properly. However, missed payments can lead to significant debt, creating a debt trap.

• Lack of Financial Planning

Not following a strict budget or taking loans for every major expense can lead to piling debts, making it harder to repay.

• Unforeseen Financial Emergencies

Unforeseen events like medical emergencies or job loss can push you into a debt trap. Having an emergency fund can help you manage these crises without relying on debt.

Getting out of debt traps might seem impossible, but it is not. The following explains some ways how to get out of the debt trap:

• List Your Essential Needs

Avoid overspending by making a priority list. Sort your needs into essential, semi-essential and non-essential items. Focus on the essential items, create a budget and track your monthly expenses to reduce wasteful spending.

• Build an Emergency Fund

It is essential to have a separate fund just for financial emergencies. Ideally, this fund should cover 3 to 6 months of living expenses. It can help you get through tough times without needing a loan. You can keep this money in various high-liquidity investment products and savings accounts.

• Choose Debt Consolidation

Debt consolidation involves taking out a new loan to pay off your existing debts. This strategy works best if the new loan has better terms suited to your financial situation. Ideally, the new loan should be more affordable than your previous ones.

• Pay Off High-Interest Loans First

Classify your loans as short-term and long-term. Short-term debts may include personal loans and credit card balances, while long-term debts could be home loans. Prioritise paying off the high-interest loans first to reduce your overall debt burden.

• Apply for a Credit Card Balance Transfer

You could transfer your credit card balance to a new card with a lower interest rate, often a promotional rate. However, only do this if the interest difference is significant and you can pay off the balance within the promotional period.

• Automate Your EMIs and Utility Bills

Set up automatic payments for your EMIs and utility bills to ensure they are paid on time, reducing the risk of missed payments and additional charges.

We hope this blog helped you understand what a debt trap is and how to avoid it. If you are planning to apply for a loan, consider the major factors and indicators that we have discussed above for better financial planning.