How to detect debt trap and exit it before it hurts your credit score

It is unwise to hang on to assets even as your liabilities keep growing due to high interest charges

Ashish Jha, a young entrepreneur, is a self-confessed compulsive spender. Worse still, he does not mind taking loans to fulfil his desires. Having been caught in a debt trap early in his life, Jha is aware of his shortcomings, but nonetheless finds it hard to curb his desire to live on borrowed money. “I am an impulsive spender. Often, when I don’t have adequate funds, I use my borrowing options and spend generously, thinking I will find the money to repay. But even though I try, I often find it hard to service my dues,” says Jha.

Are you, too, as profligate as Jha? If so, you need to do a reality check and take urgent corrective measures vis-a-vis both your financial habits and going on spending binges.  

Dire consequences

Getting ensnared in a debt trap not only messes up a person’s finances but can have a serious impact on his personal life as well. “Compulsive borrowers are always under stress. Their life becomes burdensome. Such people also lose the financial freedom that allows people to pursue their dreams and do the things they have always wanted to do. Such situations often have a telling impact on relationships and are even responsible for breakups,” says Suresh Sadagopan, founder, Ladder7 Financial Advisors.

Loan delinquency also spoils your credit score, thereby affecting your ability to access credit in the future. Lenders refuse to give loans to people whose credit scores have plummeted below a certain level (750 and above is regarded as a good score).

People steeped in debt are also constantly hounded by lenders. “If you default on your EMIs, banks will make your life difficult, to say the least. You may be forced to sell valuable assets, such as your home or land, at a loss,” warns Sanjiv Singhal, founder and chief operating officer, Scripbox.

Early signs of a debt trap

You may not see it coming when it begins, but missed EMIs and high credit card overdues are usually the first signs that you may be headed for a debt trap. “A debt trap is usually triggered by a person overloading on a variety of debt--credit card debt, personal loan, car loan, home loan, or just borrowings from friends and family--and failing to repay on time,” says Singhal. If you are not yet there but are headed towards a debt trap, here are a few telltale signs to watch out for.

EMI exceeding 40-45 per cent of income: Ideally, you should try to keep the percentage of total loan and EMI repayment below 30 per cent of your monthly income. If you do not have too many financial responsibilities, this figure can go 5 percentage points higher, but not beyond that. If 40-45 per cent of your monthly income goes towards debt repayment, it is a sure sign that you are headed for trouble.

Borrowing to service existing debt: Nowadays paying bills and carrying out online transactions using credit cards has become common. Credit card debt is often converted into EMIs. However, if you are not able to meet these fast-growing obligations on time, it is a sign of an impending debt trap. “You are clearly headed for a trap if your debt keeps increasing each month and you struggle to pay just the interest and the minimal principal back,” says Singhal.

Often, borrowers take one loan just to repay another. Basically, this amounts to kicking the debt can down the road. “If someone has to borrow more to service existing loans, he is well into a debt trap,” says Sadagopan.

How to ease your debt burden

Financial advisors say that the first step is to change your lifestyle and expenditure patterns that have brought you to the brink. “Examine your lifestyle, habits and expenses. Alter your poor spending and money-management habits,” says Sadagopan.

Singhal advises taking a hard look at expenses and ensuring they are less than your earnings. “Download your bank statement and credit card statement for the past six months and calculate your total expenses. Learn to distinguish between needs and wants. Work systematically towards reducing your borrowings. Adopt a lifestyle that costs less to maintain,” he says.

If things get bad, consider liquidating your assets to repay debt. “Many times, people have assets, including financial assets, that they do not want to liquidate. They get a false sense of security by keeping them intact. Usually it is a good idea to liquidate your assets to pay off high-cost loans. If you don’t have assets, or for some reason cannot liquidate them, as a last resort take money from family and friends to pay off your loans,” he says.

“Consolidating loans makes them easier to track and repay”

Thirty-year-old entrepreneur Ashish Jha, who found himself in a debt trap, recounts how he made his way back from the brink.

 

Which types of loans did you take?

I availed of personal, credit card, and business loans.

How much debt did you have compared to your income?

At one point, my total debt was several times my income. 

What did you do to avoid falling into a debt trap?

I reduced my expenses to the essentials and started saving. I borrowed from people without interest charge to repay my credit card bills and brought them to nil. I also consolidated my loans, which made it easier to track and repay.

What lessons have you learnt?

Convenient and flexible credit card and loans make people careless. Debt piles up over time. To control one debt, we take another one, and fall into a trap. Plan expenses and debt requirements carefully. Never use debt to finance luxuries.