Debt Trap

In this age of consumerism, we all use debt. We borrow from willing parties and in return pay to them an interest in addition to returning the principal. Loans are available to us from multiple sources and they are of multiple types. Banks provide home loans, car loans, personal loans, overdraft loans, credit companies provide a line of credit through the credit card. Other sources offer gold loans, unsecured loans etc. In fact, if you participate in a chit, as soon as you encash the chit, it becomes a loan.

A trap is anything, from which we are unable to free ourselves. A Debt Trap is a situation wherein we are –

1. Unable to pay the interest on the loans, or
2. Unable to systematically reduce the principle, or
3. Unable to pay back the principle sufficiently in time to have money available for other requirements.

If you find that one or more of the above is a reality for you, then you are in a Debt Trap.

It starts small. And very quickly becomes an out of control monster. Its fundamental genesis lies in spending more than we earn. Any debt, essentially, is a bet (or a dependency) that one will receive a particular amount in the future, and that this amount will be sufficient to clear the loan. If, for whatever the reason, this bet fails, the debt becomes unserviceable. But, the repayment (EMI or otherwise) is committed, and so we then move to increasingly expensive loan sources to clear the earlier outstanding. Having never resolved the basic issue of high spending, the debt trap only deepens. A friend of mine, having taken a 60K loan, ended up owing almost 4L in about 18 months.

Having understood what a debt trap is and its genesis, the question is how to avoid it and how to get out of it. Some rules to follow to avoid –

1. Keep outflows (necessary spending – rent, utilities, insurance premiums, EMIs, etc.) below inflows (salary, interest earnings, dividend earnings, rent, etc.).
2. Delay gratification. Keep unnecessary, uncommitted and ad hoc expenses low.
3. Be ready for loan before taking loan. Build the necessary corpus, sufficient to fund all pay backs of the loan, before taking the loan. This is counter-intuitive, but those who don’t need a loan are the ones who can/should take a loan.
4. Never take exposure to high interest loans. Set a benchmark of 10% pa, and never take a loan that charges more than this.

For those who are in a debt trap –

1. First and most important, accept and acknowledge, that you are in a financial crisis.
2. Become financially stringent and generate surplus (lump sum or monthly) to work with
   1. Take a cold hard look at your expenses and reduce it to the bare minimum.
   2. We (Indians at least) typically have value locked away in insurance policies. Evaluate them for any surplus that can be generated.
   3. Evaluate holdings (balance in bank account, money given out to somebody, equity and MF portfolios, real estate, etc. ) to get a sense of how much money can be made available, if needed.
3. Prioritise dealing with your loans in decreasing order of the interest that is charged in it.
4. Explore the options available to bring the rate of interest to below 10%pa. Simultaneously, explore the options available to increase the tenure of the loans and help spread out the repayments over a longer time frame.
5. Use the lump sums generated above to close or at least part pay any loans that are charging above the benchmark 10% pa.
6. After having exhausted available lump sum surplus, increase the EMI of the loan to the maximum of your capacity. This will automatically clearing the loan faster.
7. In some extreme cases, we may have to look at liquidating real estate.
8. Finally, and similarly important, be mentally prepared that by the time you emerge out of the debt trap, you may have absolutely no holdings, and will have to then begin rebuilding your financial security. Also, be mentally prepared that you will definitely be feeling the effects of the debt trap all your lives.

A professional financial planner can and will help you to understand and take the necessary actions towards getting financially healthy, rebuilding financial security and taking you as far as is possible towards your goals.