As consumer loans become more accessible, more Kenyans have been using them to get out of emergencies and financial fixes. The most common consumer debt incurred is digital loans through mobile money services and smartphone applications. Research published by Global System for Mobile Communications Association (GSMA) shows nearly 40% of Kenyans took a digital loan in 2021.
This phenomenon has led many people to lose their debt control management and find themselves in a debt trap. The Central Bank of Kenya governor warned that people were borrowing from one platform to pay a loan on another platform. This a classic example of being in a consumer debt trap.
So what is the consumer debt trap, and how can you avoid it? This article will explore eight ways to protect yourself from the consumer debt trap.
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Phanice, 34, is a copywriter working in one of Nairobi's most prominent advertisement agencies. Despite earning over Ksh80,000 per month, she is constantly struggling with debt. She spends over half of her salary paying consumer debts. Her biggest flaw is overspending money to show how well off she is.
Phanice recently noticed her debt problem after a digital lender threatened to list her as a defaulter on a Credit Reference Bureau (CRB). She talked to a trusted colleague about her debt problem, who recommended she sees a financial advisor as she might be in a consumer debt trap.
A consumer debt trap happens when you spend more than you make and are forced to take debts to meet regular expenses and take more loans to pay existing loans. A consumer debt trap can be caused by spending money without a budget and relying on debts to meet deficits instead of building emergency funds.
In most instances, the consumer debt trap is avoidable. It starts by taking simple steps that give you more control over your finances, put you in a better position to avoid loans, and helps you sustain existing debts.
These eight steps will help you avoid the consumer debt trap, whether you are at risk of falling into one or want to ensure you never want to deal with unsustainable debt problems.
Debt-to-income (DTI) ratio measures the percentage of your monthly income that goes toward servicing debts. It's a metric that traditional lenders like banks and SACCOs often use to determine whether to lend you money.
Let’s assume you earn Ksh80,000, and your monthly debt payments amount to Ksh38,000. To calculate your DTI ratio, divide Ksh38,000 by Ksh80,000 and multiply by 100. Your DTI will be 47.5%, which is relatively high.
A DTI above 35% can signal to lenders that you might have a debt problem, especially if most of your current debt results from consumer debt. It can also show you are headed toward a debt trap. If you spend more of your income serving debt, your remaining money won’t be enough to meet your demands. This can ultimately lead to taking more debts to pay current bills.
If you have a higher DTI (35%+), you should adopt strategies to lower it. First, you should cut personal expenses to pay off existing debts and avoid more loans. Second, you should find ways to increase your income by getting a higher-paying job or developing passive income sources.
Yes, it can be hard to buy everything you want in cash. But should you go into debt to afford the latest iPhone when your budget can buy you a cheaper phone? Or should you take a loan to buy your newborn a stroller that costs as much as your salary?
In this age where merchants always entice consumers with Lipa Mdogo Mdogo offers, it is easy to find yourself in a consumer debt trap. You might find yourself buying a lot of stuff you would otherwise afford and committing your future income to pay off debts. Such products are more expensive thanks to higher purchases and hidden fees, and they might prevent you from saving and investing.
When you spend more of your income paying debts instead of saving, you will likely end up in a debt trap.
If you are going to take a loan to buy something you can’t afford, let it be something that will add value to you in the long term. For example, a professional video editor can purchase a Ksh200,000 computer on buy now, pay later terms. It will be a consumer loan, but he will use the computer to be more productive and pay off the loan.
One of the biggest reasons that can lead you to take out loans and finally fall into a debt trap is that you lack savings to fall back to. One of the reasons people find it hard to save money is that they want to save what remains after all expenses. But this strategy can prevent savings as you will always have new expenses.
You can avoid debt traps by adopting one of personal finance's golden rules: paying yourself first. This strategy involves putting away a percentage of your income first and then budgeting for the remaining portion.
But you can’t just save money to avoid debt. You need to save with a specific goal: upgrading your wardrobe, going on vacation, or buying a home. But to avoid debt and be prepared to meet your budget deficits, you need to build a rainy day fund that will be separate from your goal savings account.
Liquidating refers to the process of converting your assets into cash. If you are overwhelmed by debts, you can sell off some of your assets, like a house or car, to generate some money to pay off your loans. Liquidating can also involve cashing out on your life insurance, borrowing from your retirement account, or cashing in on fixed investments like treasury bonds before maturity.
Liquidating can help you offset your debts and prevent you from taking out more loans. While this can improve your cash flow and save you from a debt trap, you should approach this strategy cautiously. You might pay your debts now but unknowingly be making a costly mistake in the long run.
Therefore, before you sell your house or cash in on your retirement investment, ask yourself where you will be living (can you afford to go back to renting) and how you will catch up with your retirement planning. Liquidating to settle your loans is a dual edge sword.
Impulsive spending refers to the consumer behaviour of making unplanned purchases. One of the biggest effects of this behaviour is that you might unnecessarily overspend. You will run out of money and resort to consumer loans to pay your bills and stay afloat. Additionally, if you don’t tame this bad habit, you might borrow to spend on consumer goods.
One of the reasons you could spend impulsively is because you are assured of future income. You might even go into debt knowing you will make money to pay it off. Using credit for impulse purchases can contribute to a cycle of ongoing financial difficulty, ultimately leading to a debt trap.
Adopting good money management skills like sticking to a budget, making planned purchases, and taking emotions out of your financial decision can help curb impulsive spending.
Read Also: 10 Tricks to Stop Impulse Spending in 2022
To avoid the debt trap, you need to know your limits. You need to know just how much debt you can take on without losing control. And to achieve that, you need to review your finances constantly. If, for example, you lose one of your income streams, your ability to take more debts reduces. This is because you will make less money to service more debts.
Another advantage of reviewing your finances is knowing what type of consumer loans to avoid. You will be more inclined to read the terms and conditions of the lender, understand if you can truly afford the debt, and see the hidden red flags.
Reviewing your finances will also make you more prepared, as you'll know if you are in danger of going into debt. This is because you see how adequately insured you are and how long your emergency funds can last. You can then take evasive actions to protect yourself before danger strikes, and you have to take out a loan.
Read Also: 8 Amazing Benefits of Tracking Your Spending
When you have different types of consumer loans and are on the brink of going into a consumer debt trap, there are some strategies you can use to save yourself. The first one is prioritising your high-interest loans. Go through your loans, find the ones that cost you more, and start paying them off.
But you should still pay attention to payment on your other loans. Delaying to service them might lead to defaulting depending on the terms you agreed with your lender. Ensure you service them by meeting the minimum repayments or talking to your lender about restructuring them. This can give you breathing room and make your journey to being debt free less cumbersome.
If you have different loans and all have high interest, or you can't talk your lenders into restructuring them, you should try debt consolidation. If you have many debts and are losing track of them, you can take out one big loan to pay them all. In the process, you'll only have one debt to settle. By consolidating all your loans, you can create a plan to pay it all by dealing with only one lender. But to make it work out well, you will need to avoid more debt.
Lenders use minimum payments to extract as much profit from lending money to you as they possibly can. When you make minimum payments, you are paying more interest. This could even hurt you more if the lender compounds the interest you pay more frequently.
The idea behind paying more than the minimum monthly installment is simple. It's to help you pay off your debt faster and save more money. The more you pay, the less debt you have, and the lesser the interest you pay. Consumer lenders who don't offer fixed interest will charge you interest on your remaining loan.
But before you do this, ensure you have read the terms of your loan. Some lenders might charge you loan prepayment penalties to compensate for the interest they lost when you repaid your loan earlier.
While consumer debts can help you out of financial fixes and get you something you couldn't afford, you need to consider their long-term effects. Especially when you are taking them for minor reasons, you might find yourself in a debt trap, and getting out of them won't be a walk in the park.
As you have read, consumer debt can lead to defaulting on one loan and being listed in CRB. This can make it harder for you to get loans in the future, and it will cost money to clear your name. Finally, if it was a secured consumer loan, you might lose the collateral you put up.