Everything to Learn about Debt Traps (And How to Avoid Them)

Everything to Learn about Debt Traps (And How to Avoid Them)

Falling into debt forces an individual to take out loans to pay off existing debts. Debt grows out of control over time, outstripping a person’s ability to repay existing loans and trapping them in a debt cycle. Without further ado, read on to discover and learn more about debt traps and how to avoid them.

The Beginning of a Debt Trap

Weaknesses in income, loan repayment, or asset growth can all lead to debt traps. There are two reliable indicators of debt traps: the EMI-Salary Ratio and the Loan-Asset Ratio.

Assuming an individual has a $10,000 EMI (equated monthly installment) and take-home pay of $20,000, the EMI-Salary Ratio must not be greater than 0.3.

Meanwhile, the Loan-Asset Ratio is 2.5 while the recommended number of experts is a ratio of less than 0.5.

How a Debt Trap Operates

When a person borrows money from a moneylender, two things happen: The principal loan amount (the amount borrowed) and the interest (the amount the lender charges on the principal loan amount). 

Only when the principal balance falls below a certain threshold can the individual begin repaying the loan. There is, however, a catch. The individual must make both principal and interest payments each month. Because the vast majority of loans are amortizing, this means that each loan payment is applied to both the principal and the interest.

The borrower finds themselves in serious trouble if they are unable to make payments. This is because the principal remains unchanged, and interest continues to accrue, making repayment nearly impossible. 

The Cause of a Debt Trap

Recognizing potential debt traps is critical. Identify these reasons as early as possible:

• The EMIs Exceed 50% of Earnings

As a result of easy credit, many people have developed compulsive spending habits. They are easily swayed by sales and discounts and ultimately purchase on a monthly installment plan. These EMIs may not appear to be a large sum on their own, but when added together, they can add up to a significant amount, leaving less money for other important purchases. 

You may be in debt if your total monthly payment exceeds 50% of your income.

• The Fixed Expenses Are Greater than 70% Of Revenue

Monthly financial obligations do not end with EMIs; other fixed expenses must be met as well. To name a few, rent, school fees, and utility bills. If your fixed financial obligations exceed 50% of your income, you are gradually falling into a debt trap. Experts recommend that you set aside 30% of your income for other expenses and financial goals. 

• The Credit Card Limit Has Been Exhausted

Swiping a credit card to pay for anything may be convenient, but many people reach the limit when they spend blindly. This is the time to take a step back and reassess the financial situation. 

• There Are Several Existing Loans 

Paying off a large number of loans at once can be exhausting and put you at risk of default. An individual may also be losing money as a result of paying interest on so many loans. 

• It is Unaffordable to Keep Savings

Debt and other fixed expenses can make saving money each month difficult. This is yet another sign of being trapped in debt. 

• The Loan Application Was Rejected

A rejected loan application can lead to deeper debts. Before approving a loan, banks and other financial institutions run a credit check. Banks will not extend credit to an individual if they are deeply in debt and unable to repay another loan. This is when the debt cycle manifests.

Conclusion

People must be more knowledgeable about their finances and make better decisions to secure their future. With the right guidance and spending habits, a person may reach financial freedom at an early age. The trick is to begin today to improve all financial situations! It’s never too late!

Are you looking for debt consultants in Canada? DebtHelpers.ca provides customized debt solutions for all Canadians. We can help you ease out of your financial problems. Contact us today!