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A  loan can work wonders for you, a misjudged debt can lead you into a trap. Simply put, a debt trap is a situation where debt is almost impossible to repay because of high-interest payments, lower finances and multiple loans resulting in multiple EMI payments. However, debt can be tackled smartly if you educate yourself of its dynamics. So this Independence day, let’s understand how to free ourselves from the debt snare and live financially fulfilling lives. Read On!

Step 1 : Identify the Problem 

Not all loans are bad and credit cards are not evil. However, there are some red flags that might indicate that you are either in a debt trap or heading towards them :

You Have Maxed Out Your Credit Cards –If you have multiple credit cards and you have breached or are close to breaching your limit on one or few of them, you are likely to be in a debt trap.

You Have Mounting EMIs-Missing EMI payments and incurring charges on bigger amounts is a greater risk. It becomes a debt trap when you are not able to repay them regularly and it looks unlikely that you will be able to do so in the near future.

Debt is a Bigger Percentage of Your salary- If all the debt you have borrowed from multiple sources exceeds your invested corpus, liquid cash and all other savings and more importantly forms a big portion of your salary, it is a big red flag. 

If you can relate to one or more of the situations mentioned above, it’s time to sit up and take notice. Once you have acknowledged that there could be a problem, it’s time to proceed to the next step. 

Step 2 : Prioritize Debt 

The debt you have could be short term or long term. Short term debt might include credit card or personal loans and long term might include home loans. Once you have divided debt based on tenure, start attacking loans that are more expensive in terms of interest rates, overhead charges and penalties.

Long term loans like home loans etc have a relatively lower interest rate. Whereas credit card loans can attract as high as 35-40% annual interest rate. Credit cards have monthly interest for failure to repay the bills and many hidden charges that may increase the risk of overusing them.

Failure to repay them on one or few instances pile on interest, penalty charges and the principal amount that you originally borrowed from your credit card. Therefore prioritize your loans in order of the interest rate they attract and the payback period. 

Step 3 : Plug in the Leaks and Create a Pre-payment Plan 

If you are struggling to save, first take note of your expenses. Try to cut down expenditure on non essentials like leisure trips, cinema, luxury purchases etc. Try to think of innovative ways to bring down your daily expenses, for instance, you can carpool for a while instead of taking a cab to work, or consume home cooked meals instead of frequent takeouts.

You can also look at pursuing side gigs if time permits to create extra sources of income. While this may seem like a struggle, please note this is temporary and you wouldn’t have to restrict yourself once your finances are back on track again. There are many smart budgeting apps and tools that you can use to keep a tab on your expenses. Whatever you save can then be directed towards clearing off your debts.

A smarter way would be to create a pre-payment kitty. Say your target is to clear off short term loans in the next 6 months to 1 year. Instead of letting your savings lie idle in the savings account, you can put your money in liquid funds , short term debt funds, ultra short term debt funds etc. They offer better appreciation than savings account while ensuring high liquidity and withdrawal flexibility. 

Step 4 :  Have Sufficient Insurance Cover 

Buy insurance of sufficient cover to protect yourself and your family from unforeseen circumstances. The sooner you buy insurance the lesser you would have to pay for premiums. Having insurance will allow you to focus all your savings towards meeting debt obligations without having to worry about rising healthcare costs. 

Step 5 : Request Your Bank to Increase your Loan Tenure. 

You can request your bank to increase your loan tenure for home loans if you have any. While this may increase the interest rate, it will reduce your monthly EMI payouts and also buy you some time to tackle debts. If you have a long standing relationship with your bank , you can also try negotiating on the interest rate as well. Alternatively, try transferring your existing loan to a bank that is offering you a lower interest rate. 

Step 6 : Increase Your Contribution Towards EMIs and Payments 

To pay off your loans faster, you can increase your contribution towards EMI’s proportionally to the increase in salary. 

How To Avoid Falling Into A Debt Trap in the Future?

While you are at, keep the following points in mind before you take loans again, so that you are able to manage them efficiently. 

1. Differentiate Between Good Debt and Bad Debt 

How do you differentiate a good debt from bad debt? There are some activities and assets that will need a loan to finance. At least retail customers like you and me may not have crores handy to buy a house the next morning or pay for higher education abroad. Things, where loans are not harmful like buying a house, higher education and learning a new skill, setting up a new business, children’s education and a few others may be required.

Bad debt is when you take a loan for avenues that are not a ‘need’ but a ‘want’. A foreign trip, expensive gadgets, throwing larger than life parties or any other expenditure that is not a basic need for survival need not be financed with a loan.

Before you submit that loan application, ask yourself:

  • Do I need this? 
  • Is it adding anything to my skillset?
  • In case of an asset, is it adding any sort of value?
  • Can I do without this?

2. Cut Your Coat According To Your Cloth

Let’s assume that you need to buy a new house. The first step to avoiding this from becoming a debt trap is to check the following:

  • Can you afford the loan?
  • How much of the loan can you pay back
  • How long can you afford to pay interest 
  • Is there a possibility for you to accumulate some corpus and pre-pay your loan?

For example:

Assume you want to purchase a 3 BHK 1890-sq. ft. house in Bangalore that costs you around Rs 1 crore. We used Groww’s home loan calculator to get an idea of how much EMI you would  have to pay assuming an interest rate of 9.5% and a tenure of 10 years.

If you cannot afford the monthly EMI and the total interest that amounts to more than Rs 55 lakh,then, you can probably settle for a house that is less posh than this one or wait till your income increases to be able to afford one. A loan is easy money but mounting EMIs undo all of that if you cannot afford it. 

The same goes for cars and any other asset. With higher education, you may not want to compromise on the quality of the college. Hence it is important that you curtail all other possible debts to be able to afford a loan for vitals.

An important principle for loans and debt is, Know What You Can Afford! Once you have clarity on your affordability, you will have an idea of the level of debt you can afford in your lifetime. Try sticking to that number and obeying your targets.

A smarter move would be to invest in wealth creation avenues that offer higher returns and accumulate a sizable corpus that you can use for partial or full payments. For instance, if you are in your early twenties right now and wish to buy a house 10-12 years down the road, then set aside some portion of your income every month to create a fund for your house. You can invest in a diversified equity portfolio that is in line with your risk appetite to fasten the wealth creation process. 

3. Use Credit Cards Judiciously

Credit cards are tricky and are one of those financial instruments where the advantages and disadvantages are at extremes. Credit cards have many reward points that become extremely useful in some cases; like shopping, booking an air ticket, paying utility bills and more. However, the appeal and the convenience of paying later, often leads to an indiscriminate use of credit cards. Consciously, try to spend no more than 20% of the limit on any credit card. This will not only help you clear off the outstanding amount comfortably but it’s also good for your credit score.

To Sum Up

Debt is as lucrative as it is dangerous. Mindful borrowing can actually become helpful. Taking loans for something that is adding value to your assets, your personal skills and your investment portfolio will help you to get closer to financial freedom.

A long list of bills and EMIs that are not repayable in the foreseeable future is a debt trap and keeps you away from your long term goal of financial independence. If you master the game of differentiating between knowing what you want and what you need, it may keep your financial situation healthy.

Happy Independence Day and Happy Investing!

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