Debt Trap

How to free yourself of the Debt Trap?

Debt Trap is a situation in which a debt is difficult or impossible to repay, typically because high interest payments prevent repayment of the principal.

It is absolutely critical to define the debt problem correctly, if one has to slay this monster once & for all. Looking at the debt trap through the finance prism alone, would be only as effective as treating the symptom, not the disease itself. If the root cause of debt remains unaddressed, the debt problem would re-emerge again & again, no matter how often it gets paid off.

  • Core Issue – Every financial problem is just an accumulation of many small mistakes made on the daily basis. It is a natural consequence of one’s financial habits & attitudes. Likewise, permanent solution to a financial problem is possible, only when default response of an investor prevents such mistakes from recurring. Financial mindset of a person is at the core of debt problem as well as its’ solution.
  • Own Responsibility – It matters little if debt is not of one’s own making or had low probability of occurring. Once it occurs it has to be dealt with. Probability of medical emergency, layoff, divorce, lawsuit, identity theft or some other misfortune, may be small in itself but when viewed over lifetime, nearly everybody is touched by one or more of these events at some point in time. So, one has to take responsibility for preventing or mitigating such eventuality.

Traits that lead to Debt Trap are

  • Financial Intelligence – Not understanding the functioning of financial universe & looking at money, only as means to consumption.
  • No Wealth Plan – No financial plan in place. Managing finance by responding to whatever is the immediate pressing requirement.
  • Instant Gratification – Consumerist attitude fast-tracks the slide to debt trap.
  • Extrinsic values – Seeking approval of others through symbols of wealth rather associating self-worth with one’s intrinsic values.
  • Victimhood – Justifying your situation as being victim of a financial situation as opposed to claiming responsibility in proactively dealing with it.

 

How to get out of Debt Trap?

Cause

Identifying the cause of debt overhang is more important than the financial superficiality of interest rate etc. The root cause of the problem lies in the daily habits of a person & his attitude to money.

  • Which habits led to the debt in the first place?
  • What specific situations have contributed to the current debt problem?
  • Why did the debt did not get paid off & kept on accumulating?
  • What has specifically stopped me from solving this problem?

CureBig Picture

The only cure to the debt disease is getting the financial life into positive cash flow mode. Simply put, there is no other way around than to spending less than what one earns. No matter how slow the initial progress is – pick a ‘debt producing’ habit & work on it till it turns into its’ ‘wealth producing’ alternative. Then move to the next habit & so on. It is the long-term commitment to habits geared towards wealth creation that will solve the debt problem.

The ‘Wealth Plus’ financial mindset is

  • Increase Income – Overtime, seasonal / freelance work, converting hobby into income etc.
  • Credit cards – an exception & not a rule Spending real cash connects one to the cost of things & reduces overspending. Credit cards give false sense of purchasing power. Keep them for real emergencies.
  • Limits the expensesCategorize all expenses of prior year. Shave off unnecessary expenses till planned spending is less than the income.
  • Track expense to remain within limit – Every expense should be examined for being value for money & whether it serves ultimate debt free goal.
  • No emotional spending Prepare a shopping list, so as not to overbuy & remain within budget.
  • Proper Insurance Risks (even if low probability) that could entail huge cost & debt should be insured. Also maintain reserve funds for emergency.
  • Cooling period for unplanned expenseForce yourself to wait 24-48 hours to know, if it is really needed.
  • Accountability – Acknowledge actual state of affairs to friends & family so that habit change becomes a commitment.

Medicine for Cure – Managing Debt

Have a clear path to eliminating the debt pile. The steps are

  • Organize the total debt in a manner that minimizes the monthly interest cost. Check out which of the options among debt consolidation or refinance works best, so that fresh terms be negotiated.  Any saving in interest, penalties or fees is welcome.
  • Sell any stuff that can de-clutter your life – jewellery, car, expensive watch – to reduce debt & accelerate the payoff process.
  • Structure debts – As soon as the first debt is paid off, the freed-up payment amount should be used to pay down the next debt even faster. There are 2 approaches to paying off. Debt Avalanche Approach is sorting the debts on the basis of interest rate, highest down to lowest. Paying off the most expensive debt first will lower the total interest cost. Payoff the rest of the debt will get faster. Debt Snowball Approach is sorting on the basis of outstanding amount, lowest balance to largest balance. Paying off the lowest amount & seeing immediate results is emotionally appealing. It helps one stay the course.

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