What is a Debt Trap & How to avoid Falling in to it?
Debt from loans and credit cards can help you achieve your diverse financial goals and live a comfortable life. However, the same debt can also pose a problem if you are not able to pay it back on time. This can lead to more borrowing and put you in a never-ending cycle of debt. However, there is a way to avoid this debt trap. Keep reading to find out more.
What is a Debt Trap?
A debt trap is a situation where you are left with no option but to take on fresh debt to repay your old debt. This creates a constant loop that is hard to get out of. A debt trap is usually caused when you take on more debt than you have the capacity to repay. This may be because of a miscalculation, loss of job, or if you face an unexpected financial emergency and experience a shortage of funds.
How to Avoid a Debt Trap?
Now that you know what is meant by a debt trap, you must also know how to avoid it. Here are some things that can help:
- Differentiate between your needs and wants: It is important to understand the difference between your needs and wants. Impulse shopping or mindless purchases can severely impact your financial standing. It can coerce you to take a loan or depend on your credit card beyond your repayment capacity. Buying new things may make you feel good momentarily, but they can leave a lasting dent in your savings. Hence, before you purchase anything, analyse if you truly need it or if it is only a passing urge.
- Understand your debt: There are several reasons why you may need to take on debt. For instance, you may need a personal loan to buy a television set. You may need a business loan to expand your business. Similarly, you may need an education loan for higher studies. Some of these loans may help you generate funds eventually. For example, a business loan to buy new machinery can help you produce more products and ultimately earn more money. However, a personal loan for a new television will not contribute to further earnings. When taking on new loans, try to determine if they can help you earn wealth over time. This can help you prioritize your loans and choose wisely, so you can avoid a debt trap.
- Alter your lifestyle: Making little lifestyle changes like eating in instead of eating out, walking or taking the metro over taking a cab, etc., can go a long way. Modifying your lifestyle helps you in multiple ways. Firstly, it helps you save money. You can then invest or save this money for your future goals. This way, you would not need a loan to fulfil your financial goals. Secondly, it reduces your dependency on immediate debt like credit cards. Credit cards offer convenience, but they also offer you a false sense of financial security that makes it hard to resist the desire to use them.
- Maintain an emergency fund: An emergency fund is one of the fundamentals of financial planning. An emergency fund should consist of at least 6 to 8 months of your monthly salary. Whenever you have a pressing financial need, you can use this emergency fund. If you take out funds from this account, you must also immediately refill them. Loans and credit cards come with an interest that is an unwanted expense. You can avoid this by leaning on your savings whenever possible instead of opting for loans and being in a debt trap.
Now that you know what is meant by the debt trap and how to avoid it, let’s move on to some frequently asked questions.
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Frequently Asked Questions
No, debt is not necessarily a bad thing as it can help you in multiple ways. Loans and credit cards let you buy things you need and pay for them at a comfortable pace. They also help you build a good credit score when you settle your dues on time. This helps you avail of low interest rates for your future loans. However, it is important to know how to manage your debt efficiently with proper planning and prudence.
Yes, being in a debt trap can affect your credit score. The more unpaid debt you have, the lower can be your credit score. This is why, it is very important to repay your debt on time.
- You can pay off the debt with the highest rate of interest first.
- You can opt for debt consolidation where all your debt gets consolidated under one single loan. This makes it easier to repay your debt as a unified loan rather than paying back several individual loans.
- You can liquidate your investments and savings to pay back the debt.
- You can try to work part-time to earn more money other than your primary income and slowly pay off your loans.
- Altering your lifestyle and saving more also helps to streamline your expenses.
A debt trap is a situation where your debt is higher than your ability to pay back the borrowed money.