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Why People Fall into the Loan Trap?

IndianMoney.com Research Team | Updated On Monday, May 20,2019, 05:29 PM

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Why People Fall into the Loan Trap?

 

 

Many salaried people are forced to avail personal loans for emergency needs and home loans to buy a dream house. However, debt it seems is unavoidable for the middle class. Surveys conducted by reputed agencies show people avail loans to repay existing loans. This is a sure way of falling into the loan trap.

When Do People Fall into the Loan Trap?

Job loss, a medical emergency or delayed salaries, land salaried people into the loan trap. They are forced to borrow and struggle with the high interest repayments and slowly slide into the debt trap.

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Why People Fall into the Loan Trap?

  • Your EMIs Exceed 50% of the Income

Many salaried citizens use more than 50% of take-home salary to pay their EMIs. This is a sure shot way of landing in a loan trap. Your EMI outgo must be less than 50% of your monthly income. If you have too many EMIs to pay, you would land in the loan trap.

  • Your Fixed Expenses are Too High

The EMIs paid on personal loan, car loan or a home loan, are just a part of your fixed obligations. You also have children’s education fees, rent and daily expenses. All these expenses in total are called fixed obligations. You have to calculate FOIR (Fixed-Obligations-to-income-ratio). FOIR should not be more than 50%. If FOIR crosses 70%, you are in deep trouble and on the way to the loan trap.

  • Do you Borrow to Meet Regular Expenses

Are you borrowing to meet daily expenses? You have to do something about this. You would soon have to borrow to repay existing loans and this is a vicious cycle.

People avail loans upon loans. Most citizens don’t default on car loan EMIs, home loan EMIs and children school fees. They borrow heavily using credit cards and only repay the minimum amount due. The minimum amount due on credit cards is the minimum amount paid to avoid late payment fees. This is just a small fraction of the principal outstanding each month. You still have to pay interest on the outstanding dues.

Credit cards charge a monthly interest of 2-3% on outstanding dues. The bank keeps charging interest on any outstanding dues left, after settling the minimum amount due. This means it’s several months before you clear the credit card dues. You would land in the loan trap much earlier.

SEE ALSO: 5 Golden Rules To Follow When Taking A Loan

  • You Withdraw Cash with Credit Card

Withdrawing cash with credit card means not just high interest, but also high cash advance fees. What are these high cash advance fees? Each time you withdraw cash with credit cards, you have to pay cash advance fees. This could be 2-3% of the withdrawn amounts. This is subject to a minimum of Rs 300 – Rs 500.

There is a finance charge on the cash advance fees. The finance charges are levied from the date of withdrawal, till the borrowed amounts are repaid in full. You also pay interest from the date of the transaction, till repayment is completed in full.

  • The Banks Have Refused Loans:

Banks rejecting your loan applications are a bad sign. This could mean a bad credit score. Credit scores range from 300 to 900. If your credit score is 700 and above, loans may be sanctioned. You must check credit score regularly, to get an idea on how to improve it. Check free credit report and credit score with IndianMoney.com.

  • You Avail Loans with Increasing EMIs

It’s common to overestimate future salary rise. At the start of your career, the base salary is small. It rises as you go higher in your career. Increments are lower on salary as they are on a higher base.

Availing large loans hoping the salary rises at the same rate as in the initial years of your career is a mistake. These loans may be floating rate loans and there could be a spike in EMIs, if RBI hikes the repo rates. You must be ready for a hike in interest rates of loans. Set aside a contingency fund to manage the interest rate hikes. Loans with rising EMIs can harm financial security.

SEE ALSO: Things To Check Before Availing A Loan?

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IndianMoney.com Research Team

The research team at IndianMoney.com comprises of certified and experienced professionals who share the company's vision to make every Indian financially literate by equipping every Indian with right and unbiased advice. IndianMoney.com research team provides newsletters, articles, videos and FAQs on various financial products and concepts only to help you make wise financial decisions.

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