Want to Avoid the Debt Trap? Here are the Rules to Follow

Alevin Chan
Last updated Sep 16, 2022

A debt trap can be deceptively easy to fall into, sucking away your money, energy and future. Stick to these five financial rules to avoid falling into one. 

A debt trap refers to a situation where one is stuck in a never-ending cycle of borrowing money and repaying debt

This is not to be confused with benign use of credit – such as taking an education loan to further your career prospects, or a home mortgage to start your family – even though the amounts borrowed may be significant, and paying back the loan may take quite some time. 

Instead, a debt trap is when you are barely able to keep up with your debt repayments, forcing you to borrow more and more money, and get deeper and deeper into debt. 

As your income is almost entirely used up to repay debt, you are forced to forego savings, insurance and other important expenses. You will also not have money for discretionary spending, which – depending on your personality and values – may or may not be a big deal. 

But the bigger point is, by not having spare cash to sock aside, means not having the ability to deal with emergencies that might crop up. 

When you have no money to replace your refrigerator, air con, washing machine or any number of essential household items, your only option is to borrow yet more money, which means adding more debt to the growing pile.

Read more:
4 Ways You Are Accumulating Debt Without Knowing It
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What is a Debt Consolidation Plan And How Does it Work In Singapore?

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Debt eats away at your future

A debt trap isn’t just a pesky problem for the moment, it actually eats away at your future

Every dollar that you are unable to save or invest means that’s one less dollar available to your future self. And because there will come a day when we all need to stop working, you could find yourself not being able to pay for even your most basic needs. 

Ok, so perhaps a bitter and difficult retirement may be too distant – both chronologically and in concept – to create any sort of aversion. But what about all those opportunities you will miss along the way? Opportunities to enjoy the finer things in life, broaden your horizons, fulfil your dreams or simply have better days? 

You can say goodbye to all that if you’re caught in a debt trap.

Compounding interest is why debt traps are dangerous

What makes debt traps particularly tricky is compounding interest. It’s worth remembering that the money that you borrow doesn’t come free – the lender is entitled to charge interest on your loan (which is how banks and moneylenders make money, duh).

Interest on debt is calculated on a compounding basis, which means a fresh round of interest is added on top of any amount that is outstanding or overdue.

This is most ruinous in revolving credit facilities, such as credit cards, where interest charges are added to your outstanding debt each billing cycle. This makes it easy to underestimate how long it will take you to pay off your debt

Here’s a quick example to illustrate the point:

Let’s say you owe S$5,000 on a credit card that charges 28% per annum interest. You plan to pay $200 per month to pay off the bill. How long do you think it will actually take you to pay off your entire credit card bill?

In the absence of interest, repaying S$200 monthly will allow you to pay off your entire S$5,000 debt in 25 months, or 2 years and 1 month. 

But, with the compounding interest charged on your credit card, you’ll need 3 years and 2 months to completely repay the bill, according to this handy debt calculator by MoneySense

Even worse, you’d have paid S$2,591.23 in interest charges, which means you’ve paid back S$7,591.23 on a loan of S$5,000!

Compounding interest is what trips up many borrowers, who likely thought they could pay off their debt much quicker or more easily. 

Rules to avoid falling into a debt trap 

Hopefully, by now you’re well and truly shook at the terrifying nature of debt traps. And to help you better avoid falling into one, here are some rules to follow. 

1. Don’t overspend 

Listen to your mum and don’t overspend

Spending above your means is a major reason why people find themselves mired in debt traps. Overspending eats into your next paycheck and prevents you from saving up money. 

That’s not a healthy state of affairs for your finances to be in, and the longer this goes on, the greater the danger of falling into a debt trap once an expensive emergency inevitably rears its ugly head.

2. Grow your income

Now, on the other hand, overspending is often accompanied by vigorous finger-wagging, like it’s some sort of moral failing. But due to family circumstances or some other unavoidable situation, some people simply don’t have a choice.

However, that doesn’t mean you’re stuck with no recourse, waiting for the inevitable debt trap to come along and swallow you up. Instead, what you can do is grow your income. 

Yes, growing your income is easier said than done, but this isn’t about sacrificing your health or sanity in a mad rush up the career ladder. 

It’s simply about increasing your income to balance out your cash flow and give you the ability to save up money so you can reject walking into a debt trap.

Read more:
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3. Build an emergency fund

Unexpected expenses are another major reason why people take on debt, but this can be avoided if you have an emergency fund

The whole point of an emergency fund is that it gives you an option to deal with unexpected events. This allows you the mental space to make better decisions, instead of defaulting to borrowing and thus adding to your mountain of debt. 

Even if your emergency stash isn’t sufficient to cover the entire cost, it can still reduce how much you need to borrow, which in turn decreases how much you need to pay in interest charges.

Also, pay no heed to the oft-quoted figure that your emergency funds must reach – a whopping six to 12 times your monthly expenses. That’s not a small sum by any stretch and no doubt some people get put off by the idea of it altogether. 

Instead, start with whatever amount you can set aside, and build up your emergency fund as you go along. Consistency is key, and remember, when it rains, having a smaller umbrella is better than having no umbrella at all. 

4. Watch your interest rates

We’ve expounded on the insidious nature of compounding interest, and while it’s best to avoid it entirely, there may be times when we have no choice but to pay it. That’s ok – as long as you’re taking care to keep your interest rates as low as possible. 

Perhaps in this context, it’s better to think of interest on your debt as your cost of borrowing – that’s the sum you have to pay for borrowing money or using credit. 

As shown in our credit card example above, interest rates can be deceptive, and borrowers are often unaware of how much debt they are actually incurring. 

Borrowers should weigh their options, and go with lower interest credit facilities whenever possible, such as personal loans instead of credit cards. 

If you have unwittingly taken on high-interest debt, try to restructure your debt using balance transfers, personal loans, or debt consolidation facilities

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5. Never buy on instalment

Let’s see if you can spot the difference between these two scenarios:

  1. After saving up for six months, you embark on a long-awaited road trip on the Gold Coast.
  2. You jump on a plane to London and split your holiday bill over six monthly instalments on your credit card.

All things being equal, Scenario 1 is likely to be much more satisfying, because you’ve paid off (or at least saved up the money for) the cost of your plane tickets, hotel rooms, car rental, travel insurance, souvenir shopping and every other expense from your trip. You can enjoy your holiday fully and without worry. 

As for Scenario 2, after the rejuvenation that only an overseas holiday can offer, you come home to six months fraught with financial pressure, whereby you risk incurring hefty interest charges if you miss your instalment payments, and have a lessened ability to meet an unexpected expense. 

While the first scenario is preferable over the second, that’s not to say that buying things on instalments is automatically bad. It is, however, something that needs to be managed, and not everyone has the skills and temperament for it. 

And if you just happen to fall into the camp of being bad at managing simultaneous, multiple payments (high five!) then why not save yourself the trouble and simply save up for what you want first?

You can still make use of instalment payment plans – just reserve this option for when you have to pay for essential large ticket purchases.

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Read these next:
18 Best Credit Cards For Big-Ticket Items
When Should You Use a Credit Card Instalment Plan?
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By Alevin Chan
An ex-Financial Planner with a curiosity about what makes people tick, Alevin’s mission is to help readers understand the psychology of money. He’s also on an ongoing quest to optimise happiness and enjoyment in his life.

Alevin Chan September 16, 2022 96404