InvestorQ : How do I avoid falling into a debt trap and what are the steps I need to take to ensure that I don’t fall into a debt trap?
Aditi Sharma made post

How do I avoid falling into a debt trap and what are the steps I need to take to ensure that I don’t fall into a debt trap?

Aashna Tripathi answered.
2 years ago

There are some very simple and basic steps that you can take to avoid falling into a debt trap. It is no rocket science but some basic common sense approach that can be of help to you. Here is how you go about it.

Use intermittent cash flows like bonus / capital gains etc to repay high cost loans: There are many occasions when we enjoy intermittent cash flows. It could be a year-end bonus from your employer, it could be windfall capital gains on a stock you recently bought or it was some wonderful aunt who left a share of property in your ancestral village. What do you do when you get these intermittent cash flows? More often than not, it is spent on purchasing the latest LED TV or the swanky new I-Phone in the market. A better way would be to use such cash flows to repay your high cost loans. Your credit card costs you 35% per annum and your personal loan costs you 16% per annum. When you repay these loans you are effectively earning that much on your money. That is surely a better deal!

Strictly avoid over dues; especially on your credit cards: Your bank gives you a very enticing sales pitch that you can revolve your credit card outstanding by paying just 5% of the amount. Don’t fall for that trap. Each month you are charged 3% interest which means you effectively reduce your loan by only 2% each month. Worse still; if you miss even a single credit card payment then there is penal interest plus a late fee plus GST on all these charges. You normally slip into a debt trap when you become lax in dealing with your overdue EMIs and credit card debt. That is best avoided!

No splurging please. Keep a tab on conspicuous consumption: Quite often we get into a debt trap because we splurge on conspicuous consumption. You do need to celebrate and pamper yourself occasionally but that cannot be at the cost of your financial stability. Eating out twice a month is understandable but eating out thrice a week is not only a drag on your credit card but also worsens your body mass index (BMI). You will be surprised how much you can save on your shopping bills if you try to get the best online discounts. Over a longer period of time, they can make a huge difference to your monthly budget and actually save you from falling into a debt trap.

Reduce the number of loans and negotiate with your banker: You keep picking loans because the sales rep offers it to you. Over a period of time you end up with a large number of loans with different maturities. A good way to reduce your loan burden will be to consolidate all these loans into a single loan with slightly longer maturity. You may have a longer EMI tenure but your cash flows are better managed for now. Also don’t be hesitant to negotiate on interest rates and service charges. Almost every charge in the financial world is absolutely negotiable, if you have the ability to persist.

Risk of negative equity; keep a tab on market value in case of asset-backed loans: This is slightly more complicated. We often take loans against our property or our equity shareholding. If the prices of these assets fall below a certain threshold, then the bank asks you to bring in additional margin. That is where the problem comes as you end up either losing the asset or paying margins you cannot afford. Ideally, borrow as much as your require and not as much as you are eligible to borrow. That is the golden rule!

Finally, set limits on your monthly debt servicing costs: This is an internal discipline that most of us should set when we have debt. For example, your total debt can be 2 times your assets if it includes your home loan. Otherwise, it should not be more than 1.5 times. Similarly, your sum of all EMIs should not be more than 50% of your take-home salary. This discipline is the best way to avoid a debt trap.