It may seem lucrative to avail unsecured loans and make purchases using credit, but if you are not careful about assessing your funds and making timely payments against these borrowings, you could find yourself trapped in a cycle of debt.
Once you have defaulted in terms of a payment and allowed interest rates and penalties to compound on your dues, it is a long and tiring process to crawl out of this debt trap. Great opportunities and years of wealth creation might pass you by in the amount of time you might require to pull yourself out of such a situation.
To save yourself from being consumed in a vicious debt trap, you must follow some of these basic financial tips:
You must use your credit cards wisely and not accumulate debt on them. One of the easiest ways to fall into the debt trap is by misinterpreting your credit card statement to mean that only the minimum due amount must be paid.
It is often seen that people only pay the minimum amount, while the remaining amount attracts a great deal of interest that gets compounded as more and more of the due amount remains unpaid over the next month, and so on. You must be sure of your funds while making purchases with a credit card and pay off the entire amount when it is due.
Go Easy on Loans and Purchases
Due to the easy access to credit, there is an increased affinity towards spending exorbitantly on luxury items, entertainment and various non-essential commodities. Taking loans and making extensive purchases on credit is on the rise nowadays. However, as a result of these loans, a large chunk of one's income tends to be directed towards paying EMIs.
While taking credit to create an asset that generates wealth is safe, raising funds through loans to purchase non-essential, personal items could be risky as you are not creating any similar opportunities to repay that loan. Since money is not physically being spent from the pocket, it usually does not pinch you when you are making those purchases. But this credit attracts significant interest that causes problems when the amount is to be repaid. It is easy to fall into the debt trap when you have taken a number of such loans and have not created avenues to generate money to repay your lenders.
Taking a number of loans and paying EMIs on them when you have a consistent cash flow every month might seem like a prudent decision. However, this cash flow is not your permanent income and you must not take this to be so and plan multiple EMIs based on it. It is sensible to try and restrict the cumulative EMIs for all the loans you take to under 45% of your overall income. This way not only do you avoid over-burdening your income with the responsibility of paying off all your dues and allowing for no savings, but you also account for possible career setbacks, which could potentially upset your repayment process.
Avoid Too Many Loans
Applying for various unsecured loans shows a degree of credit-hungry behaviour which makes financial institutions more wary of the risk associated with extending funds to you, especially if you already owe them money. The more loans you take, the higher is the responsibility to repay, and any shortcomings in repayment would increase the chances of you getting sucked into the debt trap. Moreover, it also becomes difficult to track the dates of due payment for each loan and the chances of defaulting increase.
In case you have taken some loans and are in the process of repaying various loans along with a variety of credit card bills, chances of being overwhelmed by this debt are quite high. This could snowball into a giant debt trap where you are left paying penalties and interest on many of these dues. In such a scenario, it is smart to consolidate all your debts into one big loan. Paying off one big debt is a lot simpler and might even attract a lesser interest rate compared to the cumulative amount you were paying earlier.
Anil Ramachandran, heads the Retail Unsecured Assets division at IndusInd Bank