From the times of Polonius, debt has been a bad word. It is supposed to be value destructive for the borrower and the lender. But why do people fall into debt traps. There are various reasons. Firstly, you could be relying too much on high cost loans and short term loans. Secondly, you may have suddenly lost out on an assured source of income and that may have created a debt trap for you. Thirdly, you may have kept postponing debt repayment to a point when your net worth may have dipped into negative territory. You are actually in a debt trap when your cash flows are not sufficient service your debts and you are holding negative equity. A debt trap not only has financial and credit score implications, but it also has serious psychological and social implications.
So, how to avoid debt trap and keep your debt within sane limits? Above all, how to avoid getting into debt traps when you least expect it to happen? Here are 7 ways to avoid debt traps. They are not complicated but more about spending discipline and meticulousness..
1. Keep your exposure to debt at not more than 1.5 times your assets
This is the first step and that is by keeping a limit on your overall debt. This not only depends on the quantum of debt but also on the nature of the debt. For example, if your debt is predominantly consisting of mortgage loans then you can go up to 1.5 times assets. However, if your loans are tilted towards consumer loans like credit cards, personal loans, auto loans etc then you need to restrict your total debt to under 1 times your total assets.
2. Your monthly debt servicing must not be more than 40% of your income
Total debt is one side of the story. The more important side is the servicing of your debt in the form of monthly instalments. In fact, most of the debt traps happen when your incomes are sufficient to service the regular commitments on loans. In fact, the best protection from a debt trap is to ensure that your total EMIs on all debt instruments put together is not more than 40% of your net monthly income. In case there is a home loan then you can go up to 50%. Please consider your net income here after deducting your tax commitments and your PF commitments.
3. Always keep a tab on market value of your net worth for negative equity
This is a very important point. Normally, in India we have seen home prices moving only in the upward direction. However, the trend has changed in the last few years. Normally, when you take a home loan you keep repaying the loan over time. At the same time your home value keeps appreciating and therefore your home equity (market value of your home – your outstanding principal) is always positive. You are in trouble if your equity becomes negative due to a crash in realty prices. In that case, your bank may ask you to bring in more margins and that could be the beginning of you getting into a debt trap.
4. Use cash flows to repay high cost debt on priority basis
This is the simplest way of not getting into a debt trap. When you get temporary inflows like capital gains on an asset or sale of ancestral property or your annual bonus; what to do? We typically look at investing in equities or buying a property. A smart way to use that money would be to pay off part of your high cost debt. You need not impact your home loan as it will hit your tax breaks under Section 80C. However, you can look to repay your credit cards, personal loans and even partially pre-pay your auto loans. When you repay a loan bearing 18% interest, you are effectively earning that much on the amount invested. If you look at it that way, you will rarely get into a debt trap.
5. Consolidate your loans into fewer loans and get them refinanced
You may be having 4 loans that are 3 years old. Your EMIs will still be at the old EMI rates and your servicing cost must be too high. You can approach your bank to consolidate these loans into a single loan. The bank will close your previous loan outstanding and create a fresh loan for the outstanding amount. You will not only consolidate your various loans under a single head but also substantially reduce your monthly EMI outflows. Remember, that extends your tenure of repayment but it is still a good way of managing your cash flows and can prevent you from getting into a debt trap.
6. Never let your overdue amounts accumulate
It is quite enticing to pay just 5% of your credit card outstanding and keep rolling it over. But you are incurring a huge cost. Similarly, when you skip your EMIs on your home loans or personal loans, you not only do you have to pay the overdue sum but also end up paying additional interest and penal charges. This kind of indiscipline in handling your loans is not going to help you. In fact, one of the best ways of avoiding a debt trap is to avoid accumulating overdue on your loan accounts.
7. Avoid impulse spending and splurging on creature comforts
This is something most of us do. In fact, if you analyse some of those around you who got into debt traps, it has largely got to do with the lure of plastic. When you get a bonus or an incentive you do not think twice about splurging on furnishing your home or a new car or a new sound system. Unfortunately, you are adding up to your credit card outstanding and that is moving you closer to a debt trap. You are surely entitled to pamper yourself but don’t stretch your finances too much.
Avoiding a debt trap is all about being meticulous with handling your debt and about being conservative when it comes to handling your finances. Maintain conservative limits and half of your job is done!