How to Avoid the Consumer Debt Trap

By
Mitch Lipka
  • Credit
  • 6 minute read

Repaying your loans is a moral, legal, and financial obligation. So here’s how you can chart your way out of debt.

Sourced from: www.financialexpress.com

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A ‘debt trap’ is defined as, a situation in which a loan or debt is difficult or impossible to repay, typically because high-interest payments create a barrier or prevent the effective repayment of the principal.  This situation becomes such a burden to consumers that there never appears to be an end and they become a ‘slave’ to the obligation.

Unfortunately repaying your loans is a moral, legal, and financial obligation. So how does a consumer avoid or navigate their way out of debt?

10 Ways to Manage Your Debt

1. Take Stock Of Your Debts:

Knowledge is power and consumers need to know exactly what you owe.  Make a list of your various debts with their equated monthly installments (EMI), interest rates, and tenures. This will help you determine the most urgent or costliest debts.

2. Always Be On Time:

Ensure your debts are being paid on time every month.  Timely payments not only keep reducing your debt through the tenure of the loan, but also save you from late payment penalties, avoidable interest, and damages to your credit score.  Save yourself the hassle and simply automate your payments when possible.

3. Create a Budget:

In order to be on time with payments and even plan prepayments, you need to know your budget.  Having a monthly budget is a vital debt management technique. The first step in the budget process is to make a note of your income and expenses. This will help you think of various ways of reducing your daily expenditure. The money that is saved can be used to clear your debt.

4. Settle Costliest Debts On Priority:

Once you’ve taken stock of your loans, target payment or prepayment of the costliest ones first. These are debts which, kept pending, will extract the highest interest. Paying high interest can drain your finances. For example, a home loan might have a relatively low rate of 8-9%, but a personal loan can be upwards of 12-15% and credit card debt could have an annualised rate of interest exceeding 20%.  Take a look at your liabilities and attack the costly loans because often they extract the highest price.

5. Consolidate Loans at Lower Rates When Possible:

If you have several loans and its difficult to keep track of them, consider consolidating them into one loan.  This simplification can help reduce the interest rates and leave you with fewer or just one EMI. Personal loansbalance transfer credit cards, and even home loan refinancing can provide you with this option.  For example, instead of paying 40% on credit card debt, you could instead move to a personal loan that charges you 15%.

6. Create an Emergency Fund:

Economic and income shocks are those situations where you don’t have the income required to sustain your current lifestyle. For example, loss of employment could lead to loss of income, which may leave you unable to meet your regular expenses such as your EMIs. As a borrower, you must ensure you have sufficient liquidity for all situations. Create an emergency fund that can sustain you during such situations. Ideally, this fund should be 3-6 times your current monthly income locked in a fixed deposit or liquid mutual fund.

7. Protect Your Family with Insurance:

Insurance helps you protect you and your family against unforeseen events. A term life insurance policy or a loan protection policy will ensure that even in your death, your family’s income needs will be taken care of and your loans would be settled. This would, therefore, help your family achieve such goals as homeownership. Similarly, hospitalization, disability, or damages to property can make it difficult for you to meet your debt obligations, and therefore adequate insurance against such risks can help your debt repayment remain on track.

8. Step Up Your EMIs & Make PrePayments on Your Loans:

As your income increases with time through your career, you should consider making higher loan payments that will help you get out of debt earlier. So make use of your investment income, annual hikes, windfalls, bonus incomes, and increase in salaries to make pre-payments on your loans or to step up your EMI. Pre-payments are normally charge-free on floating rate home loans but may attract charges on car loans, personal loans etc. However, getting out of debt is your objective, and pre-paying will help you reduce your interest out-go.

9. Avoid Loan Settlements:

When you are financially strained and unable to repay your debts, your lender may offer you a loan settlement option. It would allow you to pay part of your dues (normally the whole principal dues and none or part of your interest dues) and consider the loan “settled”. A loan settlement will get the recovery agents off your back, but the settlement will continue to reflect on your credit report, making future borrowings very difficult.

10. Keep Track Of Your Credit Score:

A healthy credit score is the hallmark of a good borrower. These days, the best loan offers are reserved for borrowers who have a ‘good’ credit score of 660 or more. If your score is below this mark, you should ascertain the reasons for it and do whatever it takes to improve it.  The reason for the low credit score could be because you have borrowed too much, or have late payments, defaults, and loan settlements. Therefore, at least once a year or after the closure of any loan account, you should refer to your credit report to ascertain that its details are as per your expectations.

In Closing…

It is very important for you to believe that there is a way out of any kind of debt-laden situation. While it may take some time, do remember that if you can create a plan and stick to it, you will be able to pay all your debts.  Hopefully, these 10 tips to avoiding the debt trap are a useful reminder of how to be wise with your personal finances.

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