How to avoid debt traps: All you wanted to know

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Updated: April 8, 2015 9:12:41 AM

Not all loans are bad. If the loan is used to create an asset and is productive in nature, it can be termed as a good loan.

debt, debt trap, loans, good loan, bad loan, financial knowledge, personal loan, money, credit card, debit card, personal finance news, financial awarenessIf you go into debt, it’s an indication that you are living beyond your means. (Reuters)

Not all loans are bad. If the loan is used to create an asset and is productive in nature, it can be termed as a good loan. Home, business and educational loans fall in this category.

On the other hand, if the loan creates no asset or is of very little productive use, it can be termed as a bad loan. A personal loan to go on a vacation or a heavy credit card swipe to buy an asset that would depreciate and an auto loan will fall in the bad loan category. They can create debt traps.

Lack of financial knowledge and discipline goes a long way in preventing people from getting into debt traps. It is important to educate people on loans, bad Cibil credit score and other issues in the personal finance space. While personal loan or any other form of non-collateral loan seem to be the most convenient option, not everyone knows the gravity of the problems one might get into.

The following table explains the different types of loans and also weighs your pros and cons:

Type of loan

Purpose

Collateral needed?

Pros and Cons

Good or bad?

Home Loan

Fund home buying or construction of a house on a plot

Yes

– Has a positive impact on Cibil Score.

– Gives longevity to your Cibil Score

– Shows intent to repay the loans

– This loan is to fund asset acquisition that is bound to appreciate

Good

Educational loan

Fund higher education either in India or abroad

Yes, if the loan value is higher. In some special cases banks do make exceptions

– Has a positive impact in Cibil score. In fact for people with no credit history, this is a good way to start it.

– This is long-term loan, therefore offering the longevity a Cibil score needs

– While there is no tangible asset for us to decide if there is an appreciation or not, since it is taken to acquire intellectual capability to gain monetary benefits by attaining a job or starting a business, this is believed as an asset that is bound to appreciate.

Good

Business Loan

Fund business expansion plans

Yes.

– Has a positive impact on Cibil score. It is being funded to either create a new asset (factory or a new location for a company) or expand an existing asset.

– This can be either a long term or a short-term loan.

– Creates more assets for the company and hence proportionate returns and profitability

Good

Personal loan

No need to specify a purpose

No

– It does not have a very positive impact on Cibil score

– The term depends on the capacity of borrower

– In most cases the asset (if any) could be a depreciating one

– Most convenient option when compared to borrowing money from inquisitive friends and painful relatives, albeit at a cost

Bad

Credit card

No need to specify a purpose

No

– Every swipe that happens on your card is considered as a loan

– It can have a positive impact if you make your payments on time and keep your credit utilisation low. Else it will have a negative impact

– It has benefits like cash back, rewards, loyalty points which bring in some freebies

-It has very high interest. So if you do not pay in time, you might fall into a debt trap

Bad

Auto Loan

To buy a vehicle

Yes

– While this could have a positive impact on your Cibil score if payments are made on time, it could get you into real trouble if you don’t pay your EMIs on time.

– The goodness of this loan is debatable. It is taken to fund an asset that depreciates over time

– If the vehicle is being bought for to aide in your business, many lenders consider it as a good reason

Good/Bad Depends on the purpose buying the vehicle

Here are top good practices to manage your finances better:

Save and then splurge: ‘Pay yourself first’, in other words, make the habit of saving a part of your income before spending. This goes a long way in keeping debts at bay.

Budget:If you go into debt, it’s an indication that you are living beyond your means. Without planning, it can be hard to know just when you are overspending. Drafting a budget for short, medium and long term expenses and tracking it allows you to see in black-and-white where your money goes.  Trim your expenses so that the total outflow is less than the income.

Use debit cards: Debit cards are tied directly to your bank account. If you don’t have money you can’t spend on your debit card. Since no credit is extended, you can’t go into debt using your debit card.

Pay off balances monthly: One way to avoid overcharging on your credit card is to allocate money from your bank account before you make any charges. As soon as the charges hit, use the reserved money to pay them off.

Invest smartly: A well researched investment can yield great returns. Keeping abreast with the latest happenings in the financial world also helps one to make smart investments.

By following the above steps, people with bad financial habits can get out of debt traps. By constantly educating oneself and by inculcating financial discipline one can successfully prevent falling into debt.

CreditVidya

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