There are all kinds of different debts. However, there is a distinction between good debt and bad debt. While being in debt is not a good thing, some kinds of debts are called good debts. Such debts may even be necessary for certain situations. However, most of the debts are bad and can leave you in an unhealthy financial situation. The worst-case possibility is you falling into a debt trap. 

So, how to avoid falling into a debt trap? To avoid such a situation, you must understand what entails the pre debt trap period. Let us learn more about debt and how to speculate a possible debt trap.

Here is what good debt and bad debt mean

Below is a simple explanation of good and bad debt:

Good debt: If your debt helps you generate money and build net worth, it can be considered as good debt. It is money owed for things that help you increase your income over time and build wealth. Debt such as student loans, home loans, business loans, etc. can be considered good debt.

Bad debt: If your loan is used to purchase a depreciating asset, it is a bad debt for you. If a debt won’t generate income or go up in value, then you ideally should not take it. For example, a loan used to buy a car, clothes, make investments, or do debt consolidation is considered as a bad debt. Also, things like credit cards and other consumer debt do little to improve your financial outcome.

 

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How may you end up falling into debt?

If you are a salaried individual or a self-employed professional with abrupt personal needs, you might have a cash crunch towards the end of the month. Often, it gets difficult for many individuals to meet their obligations. And thus, debt may end up becoming a part of your life. 

Below is how you may end up falling into debt:

Disregarded credit usage: You may resort to a personal loan or a credit card to meet your personal needs. However, this easy credit can spiral you in a downward direction. People find using credit cards easy, but they usually lose track of their spendings in doing so. As you do not have to shell out cash in the transactions you make using a card, it can considerably increase your spendings.

Lack of contingency funds for emergencies: Unplanned events like a medical emergency, job loss, etc., can force you to borrow beyond your repayment capacity. Such situations are more often than not the starting point of falling into a debt trap. You can avoid such sudden financial shocks by maintaining an adequate contingency fund. 

If you understand debt and know that you are getting into debt, you will manage and get out of it. But a debt trap is often a result of a gradual slide into debt. It is dangerous as it stays unnoticed until you are deep in debt. Many telltale indications show that you are falling into a debt trap. 

8 signs showing that you are falling into a debt trap

The most common sign is when it gets problematic for you to meet monthly expenses without taking on extra debt. However, some other indications that are typical of unhealthy personal finance and show the possibility of your falling into a debt trap are:

  • You borrow money to meet your regular expenses: If you are required to regularly borrow money to meet your routine monthly expenditures like kids’ school fees, rent, etc., you may fall into a debt trap.
  • You skip the full payment of your credit card bills: This is one of the most common and, most of the time, the first sign showing that you are falling into a debt trap. The minimum that you pay to credit card companies to roll over your credit card bills is the amount that only covers the interest component of your total outstanding bill. And if you keep on paying only the minimum amount every time, you would not be able to pay off your credit card debt even in ages. The interest on credit cards can be as high as 36% to 40% annually, and paying off such a huge credit card debt is something next to impossible. One other point to pay heed to is that even if you clear 90% of your credit card bill in a billing cycle, the bank charges interest on the total amount in the next cycle and not just the outstanding 10%. So, it is advised that you must clear all your outstanding amounts in one month rather than paying the minimum amount due every month.
  • You take on more debt to pay for earlier debts: Borrowing money to repay your current loan, taking a personal loan for debt consolidation, taking a gold loan to pay off your credit card bills, or doing balance transfer from one credit card to another, unless these activities are aimed at reducing your interest outgo, they are a clear sign of you falling into a debt trap.
  • Your total EMIs during a month exceeds 50% of your income: Compulsive spending due to schemes like discounts, easy EMIs, and offers can strain your finances and move you into a debt trap. Even if these standalone EMIs are not big, they leave you with little money left to spend on your monthly expenses when you pay your EMI obligations up. If more than half of your income is going towards paying off EMIs, it is a sign of a debt trap.
  • You are taking a cash advance on credit cards: It comes with a high cost if you are left with taking a cash advance on credit cards. The cost is typically a fixed cost along with an interest amount of around 50% per annum. Therefore, taking cash advances is one of the worst things to do to avail cash. So if you have to take a cash advance on credit cards for your monetary needs, it shows an impending debt trap.
  • Your monthly fixed obligations amount to more than half of your income: Apart from the EMIs, you also have to meet several fixed, regular expenses every month like house rent, kids’ school fees, society maintenance charges, utility bills, etc. Now, if the total of all these expenses is over 50% of your income, you are in a dire financial condition.  
  • You are meeting your regular expenses with your savings: If you have to take out from your savings or contingency funds like your emergency fund, retirement fund, children’s education fund, or down payment fund saved up for your house to meet your regular expenses, it is a sign that your expenses are mounting over your income. If you have to dip into any of your savings, it is a big reason to worry. Because in such a situation, if you are hit with any emergency like a job loss or a medical emergency, you will naturally land into a debt trap, which would be hard to come out of.
  • You are borrowing based on your future income: It is natural for people to hope for the best. But when they do that with their finances, people often fail to account for possible glitches that may happen in the future. So, borrowing money based on your current salary is okay, but you must never borrow on expected increments or bonuses as it may lead to trouble for you. So, if you need to borrow money based on your future payouts, then there is something wrong with your finances.

Conclusion

So, now you know how to identify a debt trap. There is a slight distinction between good debt and bad debt. Some kinds of debt are not harmful and often necessary, like taking a home loan to have a home of your own, a student loan to get the best education and have a remarkable career, or a medical loan to save the life of yourself or your near and dear ones. 

On the other hand, there are other forms of debt, for instance, credit card loans, which are the worst type of loans that are hardest to come out of. You must avoid credit card debt at all costs. However, you can make use of a credit card or personal loan to build your credit profile. Nevertheless, you must make sure that you pay off the entire amount owed to you at the end of the month. 

Debt is not just a financial constraint, but it also takes a significant toll on your mental health. So, you must avoid falling into a debt trap by understanding its signs. However, if you find yourself plunged into a debt trap, it is best to seek professional help.

Anil Sumra

Anil Sumra is a Digital Marketing Expert with more than 10 years of experience. He loves to write on various financial topics online to create financial awareness. He holds a bachelor’s degree in Finance & Management.

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