When you find yourself in a tight situation financially one of the options that come up to get you out of the situation is to borrow. Depending on the size of the problem you will likely have many sources to borrow from including family, friends, colleagues, peers, informal institutions and formal lending institutions. If the problem was a once-off occurrence then you may easily recover from the setback. However, in many cases, you may not be able to recover and very quickly find yourself stuck in a debt trap.

The Debt Trap

You may be familiar with debt-trap diplomacy but the debt trap isn’t limited to nations or people who had to take on student loans. The debt trap simply refers to a situation where debt is extended to a person or organisation which ends up unable to fully pay up the debtor needs to continue borrowing. From a personal finance point of view, the trap occurs when you borrow to finance current expenditure with an agreement to pay the lender from your next paycheque. The trouble here is that your next paycheque will be short. If you do not have room on your paycheque you will borrow again to finance the deficit and now you are in a trap.

It gets worse

Assuming you do not borrow any more than you need you will have a running deficit of the same amount. However, in practice, you are likely to experience another problem or obligation that will force you to borrow more and put greater strain on your finances. I’m not quite sure if there’s a mystical force behind it but borrowing becomes a habit that grows. If you’re borrowing from sources that do not charge interest you will find yourself in a better position than if you are borrowing from a source that charges interest. Interest increases the size of the future deficit.  The more or the longer you borrow the greater the chunk interest will take out of your future earnings. Meaning your need to borrow will only grow as time progresses.

If this behaviour continues the eventual outcome is the bursting of the bubble. As the need for debt grows any lender who knows their money will charge you more interest or cut you off. Remaining on this path only results in the debt growing beyond your capacity to service it. You may start defaulting on other obligations slowly or all at once but it will come. I’ve painted a real doom and gloom picture thus far but there is a way out of it.

Why are you borrowing?

You need to first be clear on why you’re borrowing. Are you borrowing for a once-off thing or is this a regular thing? If you find yourself borrowing regularly stop in your tracks and observe your behaviour. If you do need to borrow for something that recurs you would want to keep the need to borrow to a maximum of 3 months.

Change what you can

This may come off as a bit harsh but I hope the message reaches you. You are in the position you are because of past events. Not all of them are your fault but your behaviour may play a part. The only way to change things is to change your behaviour. Increasing your income is a viable idea but for most cutting expenditure is immediately actionable.

Consider the emergency fund

Hindsight is always 20-20 and suggesting an emergency fund after the fact is easy but the fact is it may be the best way to save yourself. People struggle with the idea of an emergency fund because the thought of putting away 3 to 6 months worth of income is daunting. Especially when things are already tight. However, emergency funds are houses that are built brick by brick.  A $100 emergency fund is built $5 or $10 per month, not $100 at once. The emergency fund will give you somewhere to pull funds from without going into debt.

The debt trap is an interesting phenomenon that visits people of all sorts. So even high-income individuals can be visited by this problem. What’s important is the ability to identify early on that you are walking into a potential debt trap and avoiding it as much as possible.