In this article:
- What Is a Debt Trap?
- How to Avoid a Debt Trap
A debt trap can occur when you are forced to take out new loans to repay your existing debt obligations, creating a cycle of compounding debt. Even a small new loan can push you into a debt trap if you can't repay it on time or in full.
A cycle of debt can be hard to escape, but it's not impossible. To avoid getting trapped by debt in the first place, you need to first understand what a debt trap is.
What Is a Debt Trap?
Debt is money you borrow from a lender to meet a financial need or want. If you don't make payments to your lender on time, you may incur fees and penalties, which inflate your debt even more. So, you may take out a new loan to repay the existing loan—a bit like borrowing from Peter to pay Paul.
With car loans, mortgages, student loans and credit cards, it can be easy to find yourself trapped by debt. Even so, sometimes borrowing can help smooth a rough patch. But certain types of loans—like title loans and payday loans—are risky and can lead to even more financial strain.
How to Avoid a Debt Trap
If you lose your job, rack up medical bills or take on more debt than you can afford, you may fall behind in making the loan repayments, leading to a cycle of debt that's hard to escape. Before that happens, take these steps to avoid a debt trap altogether.
Build an Emergency Fund
Setting aside money in an emergency fund may help you avoid a debt trap. You can use your emergency savings to cover things like an unexpected vet bill or daily expenses after a job loss.
How much you keep in your fund depends on your income and monthly expenses. It is best to have enough in your fund to cover at least three to six months of living expenses, such as rent, food, car payment, utilities and more.
Avoid High-Interest Debt
If you don't have an emergency fund, you may turn to high-interest credit cards, payday loans, title loans or cash advances to tide you over. Unfortunately, debt with high interest rates can increase quickly if you make only the minimum payment.
For instance, if you have a balance of $2,500 on a credit card with an interest rate of 20% and make only the minimum monthly payment of $50, it can take 106 months (over eight years) to pay off the original balance of $2,500, and you'll end up paying over $2,750 in interest. Interest can shrink your disposable income and make it harder to meet your monthly obligations.
Create a Bare-Bones Budget
A bare-bones budget covers only your basic monthly obligations. If your car needs major repairs or you lose your job, it can help keep all your expenses at a minimum so you don't end up knee-deep in debt. To get started, list all of your necessary expenses, such as rent or mortgage payments, utilities, food, insurance and the like.
Then look for expenses you can eliminate, like meals out and streaming services. Carpool instead of driving solo, or look for generic items rather than name brand when you grocery shop. Consider using a budgeting app; many are free (but offer premium tiers).
Because a bare-bones budget doesn't allow any extra spending, it can be difficult to maintain for a long time. But it can help you stay afloat in a crisis and pay down or pay off high-interest debt that's keeping you from reaching your financial goals.
Consolidate Debt
The best thing about consolidating your debts is that, after you do, you'll have one payment instead of many and ideally pay much less in interest. It can make it easier to pay on time and help maintain a positive payment history, which can have a positive impact on your credit. When done right, debt consolidation can help you pay off your debt faster and at a significantly lower cost.
There are several ways to consolidate debt.
- An introductory 0% APR balance transfer credit card: Transfer your debts to the new card and pay off that debt during the introductory period to avoid paying interest. These are typically only available to those with good credit, so they may not be an option if you've fallen behind on payments.
- A debt consolidation loan: This option might make sense if you can qualify for a loan at a better interest rate than you're currently paying. Like intro 0% APR cards, though, the best rates are often reserved for borrowers with high credit scores.
- A debt management plan: If you're struggling with a large amount of unsecured debt, such as personal loans and credit cards, a debt management plan can help. Debt management plans are available from credit counseling agencies, but they aren't available for all types of debt, such as student loans. They require fees (which may be waived depending on your income) and you may lose access to some of your credit, but if you're committed to paying off your debt, they can help you do so potentially at a lower cost than making payments on your own.
The Bottom Line
It can be easy to fall into a debt trap if you aren't careful. But how you manage your finances going forward will determine whether you stay trapped or break free. As you work to climb out of debt, it's important to your mental health to watch your progress. With Experian, you can check your FICO® Score☉ and credit report for free to see which factors impact your score the most and work to improve them.
