5 Red Flags That Show You're Falling into a Debt Trap: Escape Before It's Too Late!

Nevertheless, engaging in irresponsible borrowing can lead to complications.

Many still struggle with high-cost house loans, especially millennials and Gen Z, who are caught in a never-ending cycle of credit card debt due to their need for instant gratification.

Having said that, when debt spirals out of control, it can become a suffocating trap, draining your resources and impacting your well-being. Recognising the warning signs early on is crucial to avoid getting caught in this vicious cycle.

[Read: Boost Your Financial Savings in 2024: A Guide to Building Wealth]

Like a shimmering oasis in the financial desert, debt can lure you in with promises of ease and opportunity. But just like a mirage, its charm masks a potentially deadly danger. Before it pulls you under the sand of rising interest and crushing payments, learn to spot the red flags that warn you're teetering on the edge of a debt trap.

Even though debt is typical for many people, careful management is necessary to avoid falling into a detrimental cycle. It is important to be aware of signs that draw attention to your current circumstances and serve as a warning that you could become entangled in a debt trap.

This article will unveil 5 key indicators that your financial oasis is on the verge of becoming a suffocating quicksand, empowering you to take action and navigate towards a debt-free horizon.

Here are 5 red flags that should raise an alarm:

1. Increasing Dependence on Borrowing

Living pay check to pay check - Do you find yourself constantly relying on credit cards or loans to make ends meet? Borrowing for everyday expenses like groceries or utilities is a significant red flag and should trigger prompt measures to prevent entering a debt spiral.

Lots of people use credit cards for groceries, especially if they have one of those cards that pay cash back on grocery store purchases. Using a credit card isn't a problem. Carrying a balance is the red flag to look for.

[Read: 7 Ways to Avoid Taking Loans]

2. Rising Credit Card Bills Every Month

Regular credit card cash withdrawals result in high interest rates and fees, making them an expensive method of getting money. While taking out loans to cover everyday expenses is not a good idea, doing that with the help of a credit card is a sure way of getting oneself into trouble.

Using a credit card to borrow money is costly. In an ideal world, we would all have paid off each month's balance at the end of each month. That doesn't always happen, and that's okay.

[Read: Why Is Credit Card Debt Considered a 'Bad Loan']

However, if you have used your card to pay bills, make an effort to make large enough monthly payments to assist the balance decrease over time. If you do not have a clear payback strategy and your balances are increasing, you could be headed for a debt trap.

3. Rising Debt-to-Income Ratio

Compulsive spending may strain your budget and push you towards a debt trap. Many of you may fall prey to 'easy EMIs', 'discounts', and 'sales', these offers influence your decisions and may encourage you to splurge out of your budget.

EMIs Exceeding 50% of Your Income - which implies that you will have less money left over for other expenses and emergencies if your monthly loan payments take up more than half of your income. The majority of experts recommend that an appropriate EMI outgo should not exceed 50% of one's monthly salary, while there is no set threshold for this amount.

Even while a single EMI might seem manageable, the total impact of several commitments can leave you with little money left over for other expenses. Additionally, most banks also set limits to prevent individuals from exceeding this 50% threshold.

[Read: 7 Ways to Control Your Habit of Overspending]

Fixed Expenses Exceeding 70% of Your Income - Rent, utilities, insurance, and other fixed costs may not take up more than 70% of your income. Otherwise, you will have little flexibility for discretionary spending and debt repayment. Ideally, the Fixed Obligations-To-Income Ratio (FOIR) should not exceed 50%.

While it may not be feasible for every individual to reach the 50% FOIR, exceeding the 70% mark is a warning indication that one may be heading into a debt trap.

Credit Utilisation Ratio Exceeding 30% - this ratio indicates the percentage of your credit limit that you are utilising. A ratio more than 30% flashes a red danger flag, like a silent alarm, telling you to reassess your relationship with debt.

A high ratio may lower your credit score and make future borrowing more difficult. As a result, you may have reduced credit limits, increased interest rates on loans, and even trouble finding an apartment.

4. Taking out New Loans to Pay off Old Ones

This debt consolidation trap can lead to higher interest rates and longer repayment periods, further worsening your situation. Generally, borrowing to settle a loan is an unsustainable practice unless it results in substantial interest savings, such as refinancing a high-interest mortgage with a lower one.

You are most likely already in a debt trap if you utilise a cash advance or balance transfer from one credit card to pay off another because you are unable to make your monthly payments. Transferring funds is a band-aid solution that will only keep you afloat for a very short period of time.

However, this tendency traps you in an unending loop of interest charges and debt accumulation, making it increasingly difficult to break free from debt.

[Read: Do Not Make These 11 Mistakes When Taking a Personal Loan]

5. Missing or Defaulting on Repayments

Missing utility bills once in a while is not a cause of concern. However, if you are frequently missing paying utility bills, it's a warning sign. If you regularly fail to pay your electricity bills, this could indicate that you are overspending. Ignoring debt and avoiding contact with creditors won't prevent the issue. Ignoring calls might harm your credit score and result in legal action.

It is concerning when credit card debt is not paid in full. Missing the credit card payment or rolling it over by paying the minimum due amount is a warning sign flashing bright about potential financial troubles lurking ahead. Every missed payment leaves a lasting scar, significantly dropping your credit score.

[Read: 5 Steps You Can Follow to Create a Debt Reduction Plan for 2023]

Some Tips on Breaking Free from the Debt Trap:

If you recognise any of these red flags, don't panic! There are steps you can take to get back on track.

• Create a budget and track your expenses: this will help you understand where your money is going and identify areas for improvement.

• Contact your creditors: explain your situation and explore options like debt consolidation or repayment plans.

• Seek professional help: a financial advisor can provide personalised guidance and support to manage your debt and achieve your financial goals.

• Prioritise essential expenses: focus on paying for necessities like housing, food, and utilities before tackling discretionary spending.

• Increase your income: look for ways to boost your income, such as taking on a side hustle or negotiating a raise.

• Build an emergency fund: having savings for unexpected expenses can prevent you from resorting to debt in the future.

Additionally, procrastinating on creating a budget, tracking expenses, or seeking financial advice can worsen your situation. Taking control of your finances is essential for escaping debt.

To conclude...

Recognising the signs outlined here is the first crucial step towards reducing your debt burden. By taking action - be it budgeting, seeking professional help, or prioritising essential expenses - you can break free from the shackles of debt.

This journey might be challenging, but with each responsible decision, you rewrite the narrative of your debt. For even amidst the darkness of debt, the sun of financial freedom awaits those who dare to break free. Remember, you are the protagonist of your financial story - reclaim your control over the finances and get over the debt trap.

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MITALI DHOKE is a Research Analyst at PersonalFN. She is an MBA (Finance) and a post-graduate in commerce (M. Com). She focuses primarily on covering articles around mutual funds including NFOs, financial planning and fixed-income products. Mitali holds an overall experience of 4 years in the financial services industry.
She also actively contributes towards content creation for PersonalFN’s social media platforms in the endeavour to educate investors and enhance their financial knowledge.
 

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This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.