There was a time in my life where I’d to spend 50% of my ‘take home salary’ on EMI for home loan. Though it was a conscious decision, but I had to live with it for almost 18 months. It was a debt trap for me.
In the next phase, I paid back almost 35% of my loan by making a lump-sum prepayment. I used the prepayment amount to lower my home loan EMI.
This way my ‘EMI to income ratio’ reduced from 0.5 to 0.32. But the ratio was still high for me. Read more about loan prepayment to reduce EMI.
It’ll will be interesting to know how I got out of the debt trap. But more importantly, one must know what is a debt trap, and how people fall prey to it?
What is a debt trap?
[The above flow chart highlights the indicators which will help us to identify a possible debt burden]
‘Debt trap’ is a situation in which one falls due to overconsumption of loan. The borrower has availed too much loan, and hence is not able to repay it back to the lender.
To prevent oneself from falling into a debt trap, one must regularly monitor ones ‘debt burden‘. Why to monitor? Because gradual increase of debt burden ultimately leads to a debt trap.
There are two reliable indicators of debt burden:
- EMI-Salary Ratio: Suppose ones loan EMI (monthly payment) is $1,000, and monthly take-home salary is $2,000. In this case the EMI-Salary ratio is 0.5 ($1,000/$2,000). As my personal rule of thumb, ones EMI-Salary ratio must be below 0.30. Read more about where people spend money in India.
- Loan-Asset Ratio: Suppose ones loan balance is $100,000, and the net-asset (asset base – loan balance) is $36,000. In this case the Loan-Asset ratio is 2.78 ($100,000/$36,000). As my personal rule of thumb, ones Loan-Asset ratio must be below 1.00. Read more about how to build assets.
People who fall into the debt trap are the ones who are neither taking steps to reduce their loan balance, nor their asset growth (investments) is keeping pace with debt growth.
Why this happens? Because these people do not monitor their loan burden. How to monitor it? One easy way is to use a ‘debt burden calculator‘.
Debt Burden Calculator
|Annual Income (Rs.)|
|Net Assets (Rs.)|
|Loan Balance (Rs.)|
|Interest on Loan (%)|
|Loan Tenure (in years)|
|Debt to Income Ratio|
|Debt to Asset Ratio|
How to use this debt burden calculator? The use of this calculator is simple. Input the following five (5) data as explained below, and the output will be in the form of debt-income ratio and debt-asset ratio.
- Annual Income: Here one has to input ones gross annual paycheck. This will be that total-value which is printed on the company’s offer letter. In India, we often refer it as CTC (Cost to Company). Read more about how to stop living paycheck to paycheck.
- Net Asset: Here one must be slightly careful in calculation. Net asset will be total asset minus total loan. Suppose one has a house whose market value is say Rs.50 Lakhs. The person also has a mutual fund worth Rs.5.0 Lakhs. In this case, the total asset is Rs.55 Lakhs. But the person also has a home loan, whose current balance is Rs.30 Lakhs. Hence the net asset will be Rs.25 lakhs (55-30). Know how to build your personal asset-liability balance sheet in excel.
- Loan Balance: This will be ones ‘current loan outstanding’ reflected in the loan-account. Suppose one took a loan of Rs.60 lakhs in year 2010. By year 2015, the total principal paid was Rs.8 Lakhs. In this case the loan balance will be Rs.52 Lakhs (60 – 8). Read more about a smart plan to become loan free.
- Interest on Loan: Check you last month loan balance statement. These days banks offer the loan statement online. In the loan statement you will get you present loan balance and also the current interest rate. Enter this value in the above calculator. Read more about reducing balance method of interest calculation.
- Loan Tenure: Enter the current loan tenure. Suppose you took a home loan for 20 years. You have already paid the EMI’s since last five years. Hence, the loan tenure will be 15 years (20-5).
When debt-income ratio is below 0.30, I consider it a low debt burden. Though, the lower is the number the better. Similarly, when debt-asset ratio is below 1.00, this is also a low debt burden for me.
One must also note that, if debt-income ratio is below 0.30, but debt-asset ratio is above 1.00, this is not an ideal condition. Both the ratios must be below its thumb-rule values to pronounce a reliable ‘debt burden’ level.
How one falls into the debt trap?
People fall into the debt trap mainly due to ignorance, and bad expense management. Here I will present you few behaviour faults which leads one to a debt trap. I will also present few ideas about how one can avoid debt traps.
- Overspending: “If the EMI is low, I can afford it“. This one misconception leads majority to a debt trap. How? Because it makes people overspend. As a result, a situation comes when the accumulated EMI’s becomes too high to manage. Rule: Never buy things on credit. First build the savings, and then buy the item. Read more about how to stop overspending.
- Credit Card Dues are OK: Out of all the people who have fallen prey to debt trap, majority are victims of credit card default. It is important to realise that, if credit card bill is not paid on time, it will charge a massive 36% p.a. interest rate. Rule: Never allow credit card balance to last beyond the credit free period. Read more about why not to use credit card.
- Spending without budget: There are a lot of people who has no expense budget. But this does not mean that all of them overspend money. There are less people who spend according to their budget. But these are those people who’ll never overspend. They will never fall into a debt trap. Rule: Prepare an expense budget before you spend your next dime. Read more about 50-30-20 rule of budgeting.
- Investment is important than debt reduction: I’ve few friends who’ll vouch for the benefits of loan prepayment today. But few years back, the concept of loan prepayment was unknown to them. Today, loan prepayment is more important to them than investment. Rule: Before you invest money anywhere else, use your saving to reduce debt burden. Read more about whether to invest or pay-off debt first.
Above are the four basic reasons which triggers one to overspend and fall into the debt trap. If one can control these behaviour-faults, debt trap can be avoided completely.
Type of people who fall into the debt trap displays a common psychology. All of them has a tendency to overspend money. As a result of this tendency, such people are more likely to avail excess loan, leading to high debt burden.
In the situation of high debt burden, people are not able to payback their EMI’s as scheduled. Read more about what happens if loan EMI is not paid.
This is a situation which must be avoided in all cases. This article will help one in the following ways:
- The reader will know what is a debt trap.
- One can use the online debt burden calculator to know if one is in danger of falling in the debt trap.
- The reader will also know how to avoid falling into the debt trap.
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