A significant portion of the population, especially those with a fixed salary, inevitably encounters debt. Nevertheless, engaging in irresponsible borrowing can lead to complications. Let's examine indicators that may suggest you are on the path to a debt trap. By identifying these warning signs, you can proactively address any issues that may arise.
EMIs exceeding 50% of income
Many of us fall for the allure of 'easy EMIs,' 'discounts,' and 'sales.' Indulging in compulsive spending can strain your finances, leading you down the path of a debt trap. The constant availability of sales tends to entice those who struggle to control their impulses, often resulting in purchases on installment plans. While individual EMIs may seem manageable, the cumulative effect of multiple obligations can leave you with limited funds for other expenses. While there isn't a universally defined threshold for an acceptable EMI outflow, most experts recommend it to be less than 50% of one's monthly income. Many banks also set limits to prevent individuals from exceeding this 50% threshold. Additionally, besides fixed EMIs, one must consider the repayment of soft loans obtained from friends or family when evaluating financial obligations.
Fixed expenses more than 70% of income
EMI constitutes just one component of an individual's fixed obligations. Other fixed expenses, such as rent, society maintenance charges, and children's school fees, contribute to the overall fixed obligations. Ideally, the fixed obligations-to-income ratio (FOIR) should not exceed 50%. Although achieving the 50% FOIR might not be feasible for everyone, surpassing the 70% threshold serves as an early warning sign of potentially entering a debt trap. Experts emphasize the 70% mark because individuals require at least 30% of their monthly income to cover additional expenses and save towards financial goals.
Loan for regular expenses
If you frequently resort to borrowing money to fulfill day-to-day financial needs, it's crucial to reassess your financial situation. Consistent borrowing to cover routine expenses like rent and children's school fees may indicate a potential descent into a debt trap. Individuals who struggle to manage their expenses often resort to borrowing for regular financial obligations with the hope of repaying it later. However, relying on this strategy is inherently risky and heightens the likelihood of getting caught in a debt trap.
Loan to repay a loan
Borrowing money to repay a loan, unless the intention is to reduce interest expenses (such as in the case of refinancing a home loan), raises concerns. Another troubling indication is how individuals manage their fixed obligations. Typically, people are hesitant to default on home loan and car loan EMIs, as well as payments like rent and school fees, due to societal pressures. Instead, some resort to extensive use of credit cards, attempting to manage credit card bills by paying only the minimum required amount. This is a significant reason why cash withdrawals and the rollover of credit card dues are unacceptably high for many individuals.
Withdrawing cash from credit card
Borrowing for routine expenses to settle loans is unwise, and using credit cards for such purposes is a guaranteed method of encountering difficulties. Withdrawing cash through a credit card incurs a substantial cash advance fee, typically ranging from 2.5% to 3.5% of the withdrawn amount each month. On an annual basis, the associated interest can accumulate to a significant 35% to 50%.
Not clearing credit card dues
Failing to settle credit card dues in full raises a significant concern. According to our survey, this practice of not paying the entire credit card bill is widespread. Approximately 21% of respondents have either missed a credit card payment or opted to roll it over by paying only the minimum due amount in the past year. Many individuals may not fully comprehend the substantial costs associated with such rollovers. The allure lies in the low minimum payable amount, leading people into this financial trap. The true predicament of carrying forward credit card balances is the imposition of a high-interest rate, typically around 3% per month. If you find yourself caught in this rollover cycle, it is crucial to prioritize escaping it promptly. Procrastination will only exacerbate the issue. Consider leveraging some of your investments, especially those not tied to specific goals, to break free from the rollover trap. If repaying the credit card dues in full remains challenging, exploring the option of transferring the outstanding balance to a lower-cost loan is advisable.
Banks refusing loan
Facing rejection of your loan application from banks is a concerning indicator, especially when attributed to a decline in your credit score. Despite the credit score's range being from 300 to 900, most banks deem scores above 750 as satisfactory. While certain Non-Banking Financial Companies (NBFCs) extend loans to individuals with lower credit ratings, they typically impose higher interest rates. It is advisable to periodically check your credit score and take proactive measures to enhance it. Even senior citizens should not overlook their credit score's significance. For retirees, maintaining a good credit score is crucial because they may require loans in emergency situations. Additionally, the credit score becomes relevant if you opt to be a co-borrower or guarantor, such as for your children's loans.
Missed utility bill payments
Occasionally missing utility bills may not be cause for alarm. However, frequent lapses in paying such bills could suggest that you are exceeding your financial capacity, raising a red flag. It also indicates a potential lack of financial literacy, as this oversight can negatively impact your credit score and limit access to lower-cost funding options.
Borrowing based on future income
If you decide to take a loan now and aim to repay it when you get a fancy bonus later this year, you may be in for trouble. People always hope for the best and don't factor in possible problems that may emerge in the future. So, borrowing based on current salary is fine, but not on expected bonus, increments, etc. People also need to distinguish between the fixed and variable components of their salaries, when calculating the EMIs they can afford. Consider only the fixed pay as your salary and your EMI should not be more than 50% of this fixed pay.
Loans with rising EMIs
Many individuals tend to overestimate their future salary increments. In the initial stages of one's career, increments are typically higher, given the smaller base. Relying on the assumption that these increments will persist until retirement for the purpose of taking larger loans may not be a prudent strategy. Financial institutions also contribute to these potentially unhealthy habits by offering loan products with increasing EMIs over time, often after a few years. Since many people opt for floating rate home loans, they should be prepared for sudden spikes in EMIs resulting from interest rate hikes. It is advisable for individuals to factor in a potential 20% increase in EMIs due to rising interest rates and allocate contingency funds specifically for loan repayment.
