What Is a Debt Trap and How Can You Get Out of It?

8 min read • Published 18 February 2023
Written by Krishna Deshmukh
What is a Debt Trap and how can you get out of it?

Loan can be an excellent way to get easy access to cash when you need it the most. However, debt comes with the burden of repayment and interests which add to that burden. Mismanagement of debt can easily put anyone on the path of financial ruin. 

Being unable to pay off loans on time, causes a lot of stress and adversely affects the quality of life.Recovering from such a position can also be challenging. This type of situation that some borrowers face is called a debt trap.

In the sections below, we will cover the meaning of a debt trap and the steps to get out of it.

What Is a Debt Trap?

Often, borrowers are unable to clear the loans on time and end up borrowing more to repay the outstanding debt. This develops into a debt trap as the piled-up interest and consecutive credit bills exceed their financial capability or earnings. When EMIs are not paid on time, outstanding interests keep increasing and late payment penalties worsen the situation.

Having a loan with a relatively short tenure, high-interest rate, and large EMIs (Equated Monthly Instalments) increases one’s chances of falling into a debt trap. Certain situations like taking a short-term expensive loan, losing a job, and not having adequate savings to provide financial cover can cause a debt trap.

How to Get Out of a Debt Trap?

Although it may seem like the end of the world, you can still pull yourself out by following the tips given below.

  • Apply for Debt Consolidation

Managing and tracking multiple loans at a time can be tiresome and frustrating. To manage your loans effectively, you can consolidate your loans by applying for a larger loan. This will allow you to pay off several debts at once.  By consolidating your debt, you can freshly opt for favourable repayment terms like lower interest rates.

  •  Stop Taking Fresh Loans

The very first reason a borrower falls into a debt trap is because of taking expensive or short-term loans. With consecutive loans, it’s very easy to fall into a debt trap. 

If you have applied for debt consolidation, you have already narrowed down your outstanding debts to one large debt. Therefore, when you are having issues regulating your finances, you must refrain from adding further liabilities and concentrate on repaying your existing debt.

  • Prioritise Expensive Debt First

In case you are unable to consolidate your debts, you must prioritise paying off loans based on their expense as per interest rates, overhead cost, and the total cost that you’ll have to pay throughout the tenure. 

For example, you can pay off short-term loans like credit card bills which levy higher interest rates than long-term loans like home loans. This puts off your heavy liabilities and prevents the accumulation of massive interests.

  • Transfer Your Credit Card Balance

Another means of getting rid of high interest is by opting to transfer your current credit card balance to a new credit card with a lower APR (Annual Percentage Rate), which is often a promotional interest rate. This can help you ease down on the interest and may allow you to repay the credit loan within the stipulated tenure.

  • Lower Your Debt-to-Income Ratio

A debt-to-income ratio is a rational comparison of income and borrowed debt. It specifies a borrower’s ability to pay back their debts on time. The debt-to-income ratio helps lenders and creditors profile borrowers as per their creditworthiness. A high debt-to-income ratio indicates that the person has borrowed debt beyond their earning capability.

If you are already trapped in a debt trap and repeatedly failing to pay off the debt, you can also try increasing your income by trying on some freelancing gigs or work towards getting higher pay at work. With the higher income, you can pay off your EMIs easily.

  • Cover Yourself with Insurance

If you are already in a debt trap, you must be finding it difficult to manage your basic expenses like medical bills. However, if you have sufficient insurance coverage, you need not pay a lot for the premiums and can concentrate on utilising your savings to pay off the pending debt.

  • Request For a Repayment Tenure Extension

If you have a good relationship with your bank/lender, you can approach them for a repayment tenure extension. Although this may increase your interest payment, it will lower the EMIs and allow some time for you to stabilise your finances.

Furthermore, if you find another lender offering lower interest rates, you may consider transferring your loan to that lender.

  • Figure Out the Problem

As stated before, loans and credit cards can be excellent means of availing funds without abruptly affecting your savings. However, if you have the following situations, it could be a sign of you falling into a debt trap:

  1. Debt Higher than Salary and Savings

If the total debt exceeds your overall investments, savings, and most importantly your salary, you should consider that a red flag. It is always best to analyse and stay within your financial limit to avoid a debt trap and pay your EMIs seamlessly.

  1. Your Credit Cards Are Maxed Out

Breaching or getting close to your credit card limit can get you into a debt trap. It will lower your credit score preventing you from getting a loan for debt consolidation. Furthermore, credit card issuers can penalise you by raising interest rates and the minimum payment requirements. A very high-interest rate can put you in a loan cycle if you miss payments.

  1. Multiple EMIs

Applying for multiple EMI loans without considering the finances can drive you into a debt trap. Managing and regularly paying off multiple EMIs can be cumbersome and missing out on any repayments can affect you adversely. Therefore, it is always advisable to pay off one debt before applying for a new loan. 

  • Avoid Loan Settlement

When you are having trouble repaying the loan on time, your lender may offer you a loan settlement option that would waive off a part of your debt or interest. However, remember that loan settlement is never an ideal solution. 

The move will adversely affect your credit score and would prevent you from availing of future loans even if you pay back the settled debt. For example, CIBIL will lower your credit score by 100 points, and the ‘settlement’ record would remain for 7 years.

Some of the better solutions to a debt settlement include opting for a debt consolidation loan and balance transfer. You can renegotiate with your lender for an extension on the loan tenure or a loan restructuring plan.

  • Seek Professional Assistance

Everybody cannot be a finance expert, so it is always best to seek help. Professional financial counsellors are trained to tackle these situations and are aware of tactics and strategies to carve a way out of a debt trap. Furthermore, some counselling services also negotiate on your behalf with the creditors for lower interest rates and loan restructuring.

In addition, they can evaluate your finances and make an EMI budget based on your income which you can refer to, before applying for a loan.

Final Word

You must never forget that there’s always a way out even at the toughest moment. Although it may sound easier said than done, one must take strategic measures to recover from the debt trap, rather than taking on stress which may hinder your decision-making ability. 

If you are struggling to save funds, you can try cutting off non-essential expenditures and taking budgeting measures like eating home-cooked meals or taking public transport. But if you have good credit management skills, you will never have to worry about getting into a debt trap.

Frequently Asked Questions

Does debt consolidation affect my credit score?

When you apply for debt consolidation, the lender may pull out your credit report which is considered a hard inquiry and may lower your credit score by 10 points. However, it is only temporary as long as you manage your debt responsibly.

Does loan settlement affect my credit score?

After the loan is settled, the lender marks the loan status as “settled” which may stay on your credit report for up to 7 years and adversely affect your credit score. You may find trouble applying for a loan within this time.

How can I restructure my loan?

If you have multiple loans with varied interest rates and repayment tenure, you may contact the lender for consolidating those debts into one single debt and restructure your interest rate and tenure accordingly.

What do debt counsellors do?

Debt counsellors are professionals who have broad-scale knowledge of finances and can help borrowers with useful financial advice and debt management plans.

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Krishna Deshmukh

Investment Principal
Krishna is an investment professional with a demonstrated history of working in Debt Capital Markets. He has completed his B.E. (Hons) in Computer Science Engineering from BITS Pilani and MBA (Finance) from JBIMS, Mumbai. He is currently working as Investments Principal at Wint Wealth. Previously he worked at Kotak Mahindra Bank at their DCM desk and Northern Arc Capital at their Structured Finance desk.

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