How to manage debt: Prepayment and balance transfer options explained

If a person is taking more loans to pay off existing debts, it signals a serious debt trap situation

Debt, such as personal loans, helps individuals cover large expenses rather than waiting to build savings or spending from their regular income. If debt is not managed properly, it can undermine one’s financial wellness by creating a trap and affecting long-term savings. Prepayment and balance transfers are some methods to reduce the debt burden. In this article, we will share strategies for managing debt effectively.

 

How to identify a debt trap?

A trap occurs when the debt incurred, such as personal loans and credit cards, grows to the point that it becomes unmanageable. It also occurs when finances are mismanaged. That is, if the debt burden exceeds the income, one may end up taking on more debt to pay off the existing debt.

 

 

Signs that one may be in a debt trap:

• High debt-to-income ratio (DTI): This ratio indicates the percentage of one’s gross monthly income that goes towards debt. If the DTI ratio is 40 per cent or above, it is a sign of a possible debt trap.
• Increased borrowing: If an individual takes more loans or debts to pay off the existing debts, it can indicate a debt trap. High dependence on debt and utilising more than 80 per cent of the credit card limit is another sign of a debt trap.
• Paying minimum due: Regularly paying only the minimum due towards credit card outstanding dues can lead to a high principal amount and increased interest charges. This results in a high debt burden. 
• Poor credit score: A reduced credit score could be due to poor management of debts. Unpaid credit card bills and EMI payments and applying for loans or credit usage frequently can also impact credit history. 

 

Habits that help prevent debts from building up

Track and organise debts

As a first step, one should assess their financial situation and know the amount of debt to be paid. Organise the debts or list them and prioritise the high-interest or high-outstanding dues. At the same time, keep track of the bills with due dates closer. Remaining disciplined with debt repayment to avoid late payment charges.

Stop getting more debts

As a next step towards reducing debt burden, one should stop applying for further loans or using credit cards – at least for non-essential payments. Incurring more debt to manage existing debts is a bad decision and should be avoided as far as possible.

 

Utilise investments for debt payment

If one has additional income generated through investments like mutual funds and fixed deposit interest, these funds can be utilised towards repayment of debts. Having an emergency fund or a well-planned budget in place can manage unplanned expenses and minimise the existing debt burden. 

 

Pay more than minimum due

Merely paying the minimum due can prevent late payment fees and prevent a big impact on credit score. However, it is not a good long-term strategy and leads to a debt trap. When repaying credit card outstanding dues, one should try paying more than the minimum due to allow faster repayment of debts. 

Understand credit limits

Utilising credit cards closer to the maximum limit can trigger debt traps and reduce credit score. When one applies for a new loan, they may incur higher interest charges. It is better to keep the credit usage less than 30 per cent of the maximum limit.

Go for debt consolidation

If a borrower can get a personal loan at a lower interest rate, the amount can be utilised to pay off many outstanding debts. This is known as debt consolidation and reduces the debt burden significantly by eliminating the burden of many high-interest debt payments.

 

Prepayment and balance transfers

When dealing with a debt trap, there are surplus funds, prepayment is a smart move. However, the decision should be taken after allocating for basic needs and saving for emergency funds. Prepayment of a loan can bring down the interest charges. It is also important to consider prepayment charges before making a decision. 

 

Individuals dealing with a debt trap can consider credit card balance transfer by moving to a new card with lower interest rate often available in a set promotional period. Before going for it, it is necessary to do the calculations and check if the interest difference is high and payment can be made within the promotional period. Balance transfer of loans is also possible by moving to a new lender offering lower interest rates. However, this makes sense when the transfer costs remain below 1 per cent of the outstanding amount.   

FAQs

What red flags should one notice to avoid debt traps?

Too much dependence on credit cards and loans is a clear red flag of a possible debt trap and should be avoided. Other common red flags include paying only the minimum due on credit card bills and missed payments of debts. 

 

How to prevent most of the damage caused by debt? 

By immediately stopping incurring further debts and being consistent with repayment of debts can prevent most of the damage caused by debts. To avoid increasing the debt burden, one should focus on paying off the high-interest debts first. 

 

When does the debt burden become alarming?

If a person ends up taking more loans to pay off existing debts, this can signal a serious debt trap situation. It needs immediate action by stopping further debts. Instead, one should utilise income from investments to pay off debts. 

 

How should the debt management plan be reset?

Debt management plans should be reviewed and reset based on one’s financial situation. This should be done, especially when there is a change in income level or change in the amount of outstanding debts.