Debt Traps and How to Spot Them
Debt can accumulate fast, particularly if you need to borrow money to pay your existing debt each month. This is known as the cycle of re-borrowing and occurs when you are unable to afford your current debt repayments, whether it is your home loan, car loan, credit card or personal loan.
What is a Debt Trap?
A debt trap is a situation in which a borrower is stuck in a cycle of re-borrowing to pay the interest or other debt. This makes it difficult for you, the borrower, to repay the money you owe because the interest accumulates and missing a few payments can land you in a debt spiral.
Debt Trap Characteristics
Short-term high-interest rate loans such as Payday loans are usually easier to obtain than long term secured loans such as car loans and home loans. And it is short-term high-interest rate loans that borrowers frequently turn to, to repay existing loans.
Such loans may appear to be a quick fix to deal with a short-term cash flow problem but can be a huge financial burden.
These loans take different forms, but most have one or more of the characteristics below:
- Short repayment terms. For instance, such loans must be paid off in 6 months to a year and interest accumulates every 30 days on the capital.
- Automatic credit limit increases. Lenders offer you more money without you even asking for it, which makes it tempting to borrow more.
- Low minimum repayments. If you pay only the minimum amount due on the loan, the interest accumulates and the debt may actually increase.
How Short-Term Loans Work?
- When you borrow money, your repayment can be allocated to either the capital amount which is the amount you asked to borrow; and/ or
- The interest cost on the borrowed amount.
You will only start reducing your debt if your monthly debt repayment is large enough to cover the interest and reduce the capital amount. If you are only repaying the interest your loan capital will not reduce and the interest repayment will continue indefinitely unless you are able to settle the loan with a lump sum such as your annual bonus.
Common Debt Traps
- Credit Cards – This is the number one debt trap. Not used responsibly, credit cards are dangerous for a number of reasons. Firstly, they are relatively easy to get, secondly, the credit facility (the amount you can spend on the card) is usually double the applicant’s income and, lastly, the bank often increase your credit facility especially if you have been paying your card regularly. If the capital (the amount you spend) is not repaid each month, it will increase and will attract more interest until it is settled in full.
- Store Accounts – Store accounts, like credit cards are easy to obtain and the amount you spend – and need to repay – can quickly get out of hand. You pay exceptionally high-interest rates on store accounts and if you do not manage it and make regular repayments, you can find your credit score negatively affected.
- Personal Loans – Personal loans also attract high-interest rates and some personal loans incur additional fees for the application and early settlement.
- Overdraft facilities – Overdrafts offered by banks on your bank account, may provide flexibility in managing your cash flow but can easily turn into a debt problem. Overdrafts are a form of short-term credit. If you earn, say, R5 000 a month, the bank may allow you an overdraft of say, R10 000. and if you are not careful your entire paycheck can be swallowed up by the overdraft facility. This can leave you living on debt which is a dangerous situation for your financial health.
Being aware of potential debt traps can help you avoid them.
Are You in Debt?
A key indication that you are in debt is when your monthly income cannot cover your monthly living costs and debt repayments. A large percentage of South Africans are overly indebted.
If you need help to get your finances back on track, talk to one of our NRC-registered debt specialists about a tailored debt solution to help you regain control of your money.
Fill in the form on the right and one of our specialists will be in touch to provide you with a FREE debt assessment.