How to avoid a debt trap?

Avoid the debt trap

In the current day and age, credit is available at the tap of a button. It is very important to ensure that we avoid a debt trap. Once we fall into the debt trap, it is very hard to escape the debt trap. Debt offers a great way to leverage our resources, but if left unattended, then it can spiral out of control and make our life a living hell.

Here are a few ways to utilize the leveraging power of debt and ensuring we do not fall into the debt trap:

1. Understand good and bad debt to avoid debt trap

A loan taken for the purpose of bettering us and our family is always considered a good debt. Some examples of a good debt are, home loan, education loan, loan for a new business and a few others.

However, loans taken to satisfy wants and not needs are generally classified as bad debts. Loan taken to satiate a want for pleasure such as a foreign trip or sporting the latest gadget is a bad debt and can hang around your neck like a millstone.

Before we take a loan, we should try answering a few questions:

  1. Can I live without this?
  2. Is it a depreciating asset?
  3. Does it add value to me or my family?

These can help us identify a bad and a good debt.

2. Live within your means

Once we have decided that the loan is essential to uplift our life, we need to decide the size of the loan and assess the impact it is going to have in our life. If we decide to buy a house, we first need to fix our budget, the tenure for which we wish to take a loan, and the monthly payout we can afford.

If you buy things you do not need, soon you will have to sell things you need

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If you cannot afford the monthly EMI payout, it would be wiser to settle for a smaller house or a house in a less posh area. This would give us peace of mind and also allow us to enjoy the other pleasures of life

3. Careful with credit cards

Credit cards have massive advantages and equally big disadvantages. They can help us purchase stuff without actually shelling out cash, but miss one payment and the interest component will just kill you. Credit cards offer reward points which can be redeemed for shopping and traveling. However, credit card interest is high as 40-45% annualized. It is very important to manage the use of credit cards. Missing a credit card payment can harm our credit score and make it tougher to obtain loans in future. Ideally one must aim to spend less than 25% of the credit card limit.

Saving leads to investing

When we avoid falling into a debt trap, we can save up more money for investing in different assets, and following a healthy financial habit can help us to multiply our wealth several fold, thus helping to step off the gas in our twilight years.

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