To learn how to avoid debt trap
1. What is a Debt trap?
When an individual/company takes one debt to repay another debt, it is known as “Debt trap.” It creates a cycle wherein the second debt becomes expensive and there will be no scope to get access to any future debt. So, the person will get completely stuck into a debt trap.
A debt trap is a situation where an individual, business, or country becomes stuck in a cycle of borrowing to repay existing debt, leading to an increasing burden of debt over time. This occurs when the amount of debt owed becomes so large that the borrower is unable to make timely repayments without taking out more loans, which only worsens the financial situation.
Debt traps can arise for various reasons, including:
High interest rates: High interest can cause borrowers to pay more than the amount they originally borrowed, making it harder to pay off the original loan.
Inability to generate sufficient income: If a borrower’s income or revenue is insufficient to meet repayment obligations, they may borrow more just to maintain the loan, causing the debt to increase further
Short-term borrowing for long-term issues: Borrowing for immediate needs without a long-term strategy for repayment can create a cycle where the borrower needs to constantly refinance or borrow more to pay off previous debt.
Poor financial planning: Lack of budgeting or mismanagement of funds can cause debt to accumulate without the means to manage it effectively.
For example:
- Mr. Ram is a salaried person with a monthly income of Rs.50,000.
- Apart from monthly expenses, he is paying a car loan and a home loan for 30 years as well.
- His major part of income is spent in EMIs and he faces a medical emergency wherein he has to take one more personal loan.
- So, he is stuck in a debt trap wherein he has to take new debt to repay the old one.
2. Reasons for debt trap
Debt trap arises due to lack of financial planning about:
- Monthly income
- Monthly expenses
- Loan worthiness
- EMI Payment
For example:
- Mr. A took loan of Rs.20-30 lakh for his e-commerce business with a hope that he will get success as e-commerce business as it is quite popular during lockdown.
- The traffic on the website is not as per his expectations and he has used his loan amount in buying goods, paying salaries, building rent, etc.
- This will create a challenge in repayment of his loan and he will face debt trap.
3. Interest and its types
Interest is the cost of debt charged by the money lender from the borrower.
Types of interest:
Simple interest
- Principal amount: Rs. 1,00,000.
- Duration: 3 Years.
- Interest rate: 10% per annum.
- Simple Interest (SI) = 1,00,000 x 3 x 10/100= Rs.10,000
- Principal amount will be same every year i.e. Rs.1,00,000.
Compound interest
- Principal amount: Rs. 1,00,000
- Duration: 3 Years
- Interest rate: 10% per annum
- SI = 1,00,000 x 3 x 10/100= Rs.10,000
- In case of compound interest, Rs.10,000 i.e. interest will be added in principal amount i.e. Rs.1,00,000. So, the principal amount will be Rs.1,10,000 for the second year.
So, you should consider the type of interest while taking loan.
4. How to overcome debt trap?
- Consult a financial advisor.
- Financial planning on your own.
- Monthly income: You can increase your monthly income through other sources.
- Monthly expenses: You can reduce your unnecessary monthly expenses to avoid debt trap.
- Monthly EMI: You can plan your monthly EMI accordingly.
- If your business is at dead end, you can file personal bankruptcy in the court of law. Court will reassess your total assets and total liabilities and take the decision accordingly.
Key Outcomes
- Do financial planning to overcome debt trap.
- Check whether it is simple interest or compound interest while taking debt.
- File personal bankruptcy in the court of law if your business is at dead end.
- Reduce your unnecessary monthly expenses to avoid debt trap.