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Are You In A Debt Trap?

Debt Trap

What is a Debt Trap?

A debt trap is the situation where your total monthly payments exceeds your income.

What is a Debt Spiral?

A debt spiral is a situation where you increase your level of debt in order to pay existing debt.

Failure To Plan Is A Plan To Fail

Most people who get into a debt trap are not monitoring their cashflow accurately and don’t see it coming. They do not track their spending or prepare for the unexpected.

An Example of a Debt Trap/Spiral

Consider this, you have an income of $1,000 per month and regular expenses of $700. You get a credit card and for some time keep a balance that only requires a $150 a month repayment. But the interest is so high that you are only reducing the balance by $10-20 a month. So the monthly minimum repayment shrinks ever so slowly, and now you want to buy something else. You either increase your limit or get another credit card. So now your repayment is $300 a month and you are break even - $1,000 income and $1,000 expenses.

 

All of a sudden something big breaks (like your car) and you have to repair it (as it gets you to work), but you have no spare cash for this large bill. No problem, you just increase your credit limit again. Now your expenses are $1,200 and month and you are losing money. So you get another credit card and use it to pay the first one, but while you manage for a while your expenses increase to $1,500 a month. This cycle continues until your cannot get anymore credit because the lenders believe you cannot service the debt with the income you earn. Then the debt collectors come knocking and you have to sell possessions (which are worth only half of what you paid for them) to repay the debt or worse, you can’t pay at all and end up in court. You are declared bankrupt.

Many People End Up Bankrupt

Bankruptcy is the situation where you cannot pay those that provided you credit and they ‘must’ get their money back. This is a serious and complex situation which varies from jurisdiction to jurisdiction. I won’t go into this in detail, but I will say one thing – THIS IS TO BE AVOIDED LIKE THE PLAGUE. The ramifications will affect you for the rest of your life and make life very difficult.

Banks must get their money back as the money they lent you is not theirs, it belongs to people who have loaned it to them, like mum and dad depositors. Suppose you deposited $10,000 in a bank who loaned it to someone else, then the other person could not pay it back. Would you give up your $10,000 or want it back? Banks make their money making a very small profit (percentage-wise) on all transactions, including loans.