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Debt cycles and how to avoid them
Most of us get into debt. Credit enables us to invest in the here and now and make plans for the future. But getting trapped into a debt cycle can be difficult or almost impossible to escape.
There is a way out.
Mortgages, student finance, investment in home improvements and buying a new and reliable car. All are “good debts”, so long as you can make the repayments and settle the balances.
But other types of lending can lead to problems if you don’t manage them properly or find yourself unable to.
Short term loans are a lifesaver for many. Payday loans have a higher level of interest than other ways of borrowing. This is because they are intended for short term use only.
Taking out a payday loan and repaying it when it is due does not usually trap you into a debt cycle.
Under the rules of the Financial Conduct Authority, if you were to take out a loan of £100 for 30 days until payday, the extra amount you would pay back is capped at £24.
That need not be a problem for most people. The danger comes if you have to take out a new loan to pay off your old one. Or if you have to “rollover” the loan for a longer period.
This can easily become a cycle. And it can be a cycle which it is hard to break free from.
What is a debt cycle?
A debt cycle is continual borrowing that leads to increased debt. A debt cycle increases the level of personal debt, increases the costs associated with it and can lead to falling behind with repayments, missed payments and eventual default on credit.
Debt cycles often result from a simple equation. If you pay out more than you bring in, debt increases faster over a period of time.
Eventually, if not resolved, the amount you have to repay and the interest costs become a significant weekly or monthly cost.
This can lead to a need to borrow more and more to pay off existing loans just to keep up with monthly repayments as well as spending on essentials like food, travel and clothing.
Payday loans can cause a quick spiral into a short term lending trap.
If you have think you will have difficulty repaying a payday loan, you may be able to get an extension. This is known as a deferral or rollover. Or you might be able to take out a further loan to repay the existing one, perhaps with a little more, over a longer period of time.
Rules mean that you are limited in how many times you can roll over a loan. So this offers you some protection.
Rolling over your payday loan is not necessarily a bad thing. It gives you a little breathing space after all.
But rolling a payday loan several times can soon lead to problems. It means you will have to pay back more in interest and other fees at a later date. This only extends the length of the debt cycle and increases the impact.
Credit cards are one of the other main ways of ending up in a debt trap. With a credit card, the main way you can get caught in a cycle of debt is by only making the minimum monthly payment, rather than paying off your balance. This often means you are only really paying off interest and not the capital of the loan. In this scenario, it can take an awfully long time to repay the credit card, sometimes if ever.
How a debt cycle causes problems
A cycle of debt is likely to end up ensuring you have to go without on some things each month or have to rob Peter to pay Paul. This only makes it worse.
In the worst-case scenario, if a debt cycle has gotten out of control, you might have to apply for some form of debt relief or even bankruptcy.
Falling behind with payments, incurring defaults and debt relief schemes seriously damage your credit score. And those negative entries will stay on your credit file for quite a long time.
This can make it difficult to gain credit in the future. It can also impact on your ability to rent a property, and if loans are secured to a house or car you could risk losing them.
How to get out of a debt trap
There are some simple steps you can take to avoid a debt cycle. Be mindful of your spending limits, make sure you read the paperwork that comes with credit, and keep a close eye on your financial accounts.
If you do have problems, stop and think. If you need advice, often the earlier you do so, the better. Talk to the lender. They would prefer to discuss your situation and perhaps receive a little less than nothing at all.
If you are worried, free money advice is available from a number of places. A good place to start is the government’s Money Advice Service.
There are ways to avoid a debt cycle and set yourself up for financial freedom.
Be budget aware
To avoid a cycle of debt you need to know what you’re working with. That means drawing up a budget and setting a spending limit.
Total up your monthly income and your regular expenses. You may want to add to set a budget for items which can vary such as food shopping or leisure expenses. Write them all down, use a spreadsheet or download a budget app or use an online site.
If your income is less than your outgoings, don’t panic. You are not alone. An awful lot of people don’t break even every month.
But this will mean you are at risk of incremental debts building up over time, or of getting trapped in a cycle of debt. This can be sudden should an emergency crop up.
Brainstorm ways to cut back so you don’t have to borrow or rely on your credit card or payday loans each and every month.
There are ways to reduce bills. For example, looking for a cheaper deal by switching utility suppliers or insurance providers. Help is available to many people for regular monthly expenses like council tax or childcare payments
Or consider ways to boost your income, for example by taking on a side gig. The internet offers a whole world of working from home opportunities for additional pocket money. Think of something you’re good at – it could be writing, making things, or selling as a sideline – and research how you could make it happen.
Check in on your spending habits. If you’re heading to the shops, draw up a shopping list based on your budget and what you really do need.
Impulse purchases are all too easy. Even more so online. One tip to avoiding mindless shopping is to wait a little while before you actually buy the item you have identified. Pause for a few hours or sleep on it. Have a little think and ask yourself, do I need this? You’ll often find you may change your mind later in the day or the following morning.
Pay more than the minimum payments on credit card balances
Only making that minimum payment on a credit card each month can get you caught in a cycle of debt. Each month you fail to pay off your balance in full, interest starts to add up. Credit cards can have high rates of interest.
Go back to your budget and consider whether you can pay a bit more each payday to bring the balance down, or better still, pay off the amount owed in full every month to avoid hefty interest being added.
Only borrow what you can afford to repay
Lenders are required to make sure you can afford to repay what you borrow. This offers some peace of mind and is designed to ensure you don’t overstretch yourself.
But you need to take a little personal responsibility too. Once you get in the habit of keeping track of your budget, you will get better at understanding your own lending limits and how much you could afford to repay each month.
Set up an emergency fund
Emergency expenses are a common way to get stuck in a cycle of debt, especially if you’re living payday to payday – or even worse, payday loan to payday loan.
Between three and six months of your monthly expenses saved up in an emergency fund is usually considered a good safety net. Even putting aside a small sum each month into a separate savings account will soon add up. This is also a good idea for things like Christmas, birthdays and the annual summer holiday. It doesn’t have to be a lot, but every little bit will help.
You can then use the money towards the amount you need to borrow if your car breaks down, your home needs repairs, an appliance stops working or another expense pops up. You don’t need to have enough to pay the bill off in full. Anything and everything you can put towards the cost will free up cash for other things. And it will make you feel good too that you have done something positive.
Build your credit
Having a low credit score can significantly limit the options you have when you’re looking for a loan. Building your credit score before you need to borrow opens up more options – often cheaper.
Checking your credit score and thinking about the things that will positively impact it also gets you in the habit of thinking about your financial health.
A credit-builder loan or credit card can help increase your credit score. Make sure you make the payments required regularly and settling the balance will be viewed positively on your credit file.
Stay away from hefty final payments
Sometimes, credit is offered which includes a final payment higher than the regular payments. This often happens with car loans, for example.
While deals of this nature can be tempting, they have drawbacks. Such a scheme may lower your monthly repayments but you will have to find a way to make the final payment eventually. You could have trouble affording it if you don’t save up for it. Don’t be tempted to think your financial situation will have improved by the end of the term or to worry about it later.
Some borrowers who can’t afford the final payment take out another loan to fund it. This leads to more interest and fees to add up – and potentially another debt trap.
Weigh up all of your options before you borrow
Know what you’re getting into, and read up on how the loan compares to alternatives out there.
If you have bad credit and need money right away, often a payday loan is your only option. Borrowing from friends and family can be a cheaper option.
Think before you renew or rollover
Refinancing, rolling over or renewing a loan can be particularly dangerous when it comes to short-term loans like payday loans if you overdo it.
Rolling over usually involves paying a fee to push the due date of the loan back for another few weeks. This shouldn’t be a problem occasionally. But doing it too often is one of the easiest ways to get trapped in a cycle of debt. It is best to avoid renewing unless you really have to and there are no other options. Rolling over makes payday loans expensive with added fees and interest.
The bottom line
There are occasions when taking out a short-term loan or spending sums on your credit card is unavoidable. But getting trapped into a debt cycle is all too easy. It doesn’t have to happen if you only borrow what you need, read the fine print, research all of your options before pulling the trigger and make timely repayments.
Take control and stay on top of your finances. Prepare for those unexpected situations that inevitably happen from time to time. Avoiding the debt trap can be difficult, but it is even more difficult once you’re sucked into the cycle. Some simple steps – even taken little by little – will reap big rewards.