4 Common Debt Traps to Avoid

Posted on July 11, 2010 in Business and Economy

By Guha Rajan:

About a decade back, getting a loan had its own challenge. One had to visit a bank a number of times and provide all the needed document/security before getting a loan. This has changed drastically in the last 10 years.

Most of us would get a call from a bank almost on a daily basis about loans & credit cards. It’s easy to get loans these days, but you need to ensure that you have sufficient fund flow with you before taking up the debt route to finance your needs.

Like a businessman one has to effectively use Loan (Debt) and his own funds (equity). Heavy burdens of loan can get you easily trapped onto the path of Bankruptcy. Let’s see some of the commonly used loan facility.

Credit cards : A nice financial instrument if effectively used and can be a financial killer if abused. No longer does one need to carry cash one’s wallet and ensure its security, if effectively used, one gets 45 days credit. Further, these days, one gets life time free cards. Just paying the minimum due can drag you into the debt trap. Plan to pay at the end of your credit period. If you feel that you would not be able to pay up, its better to postpone purchase unless it’s a necessity. It’s not wise, to pay credit card dues through a loan, unless it’s available at your disposal for almost negligible interest rate, if not Zero.

Home Loan: The concept of Home Loan has changed drastically in the last 8 to 10 years. Now one can get home loans without visiting banks. A few years back, the Equated Monthly Installment (EMI) was almost equivalent to the rent paid for an accommodation, hence it was wise to own a house, since at the end of a loan tenure the house or apartment becomes your property. The same is not true now adays, in the most cases rent is almost 1/3rd of the EMI, in case if you have opted for 85% financing through loan.

With property prices sky-rocketing in recent years, one has to also take into account depreciation opting for a flat. This being the case, if one calculates the total capital outflow till the end of the loan tenure v/s the flat appreciated value, the total capital outflow might end up higher. One might also end up paying more interest as compared to the tax benefit available. It’s better to keep home EMI 30% to 40% of the take home pay and make a decision after some home work is done.

Consumer loan: Any consumer product can be procured through loan, particularly vehicle loans. Considering the fact that consumer products have highest depreciation, it’s better to look at your needs rather than looking at the luxuries, while opting for this loan.

Personal loan: Personal Loan does not have a high tax rebate and interest rate. these loan has to be used only if case of emergency. Personal loan & credit card loan are the first one which need to paid off as soon as money becomes available. The interest rate is much higher than on a home loan.

Always keep a check on the cash outflow on a regular basis and ensure some savings in the form of alternative investment made on a monthly basis. Also, it is imperative at any point of time that the total of all your EMI is not beyond 50% of your take home monthly income. Though there is no hard or fast rule, it’s easier to save money from an early age (between 20~30 years) than at a later stage (40 + years) of your life due to commitment one gets.

Your pay check might become heftier over the years, but so do inflation and commitment over the years. Hence, one needs to work according to a financial plan.

Remember, these days credit default information are updated into the database maintained by Credit information Bureau (India) Limited. Hence, it is better to not get into a debt trap, which can prove much expensive.

The writer is a correspondent of Youth Ki Awaaz.