Managing your finances is often challenging, especially in a world of continuous financial pressure.
Debt can be a useful tool to help you borrow the money you need, especially for larger purchases. However, too much debt can become a burden that causes stress and limits your financial freedom, ultimately leaving you in a debt trap.
So, how do you avoid falling into debt, especially during a financial emergency?
To help you navigate this issue, this article will explore debt traps, types of debt, and some actionable tips to avoid debt traps and manage your finances responsibly.
What Is a Debt Trap?
Debt trapping occurs when frequent borrowing results in a cycle of growing debt that becomes increasingly challenging to manage or repay.
Debt traps are often the result of financial emergencies, high-interest loans, unexpected expenses, or poor financial planning. As a result, people can find themselves trapped in a cycle of taking on new debt to pay off existing debt.
Differentiating Between Good Debt and Bad Debt
The first step to avoiding debt traps when facing a financial emergency is understanding that there are two types of debt, namely good debt and bad debt.
Good debt is a helpful tool that can help you out of a tough situation, improve your lifestyle, or make a large purchase, for example a house. This type of debt pays for itself over time, such as mortgages and business loans.
On the other hand, bad debt is any money borrowed for purchases that don't increase in value or help generate income. These debts can often carry high interest rates, for example, credit card debt or car loans. That’s not to say that using debt to buy a car is necessarily a bad thing, only that a car is an asset that will decrease in value over time.
The main difference between good and bad debt is the amount of interest the borrowed money will accrue over time. A good debt is when your (the borrower’s) return on investment (ROI) is more than the interest cost. However, when the return is lower than the interest cost, you’ll end up paying more interest than what you’re getting back in value. These are considered bad debts, and a potential cause of debt traps.
By distinguishing between good and bad debt, you can develop a strategy on how to avoid debt traps and effectively manage your finances.
3 Tips to Avoid Debt Traps in Financial Emergencies
When learning how to avoid debt traps, there are many things you can do. Let’s explore some tips that you can implement to avoid debt traps during a financial emergency.
1) Create an Emergency Fund
One of the reasons most people end up in a debt trap during an emergency is a lack of an emergency fund. Setting up an emergency fund is a vital step in learning how to avoid debt traps during unexpected financial setbacks.
While creating an emergency fund might seem unnecessary, especially when money is tight, there will come a time you’re grateful to have it. An emergency fund serves as a financial safety net that reduces your reliance on high-interest credit options when facing unexpected expenses.
If you want to build an emergency fund, you don’t need to start with big amounts of money. Saving small manageable amounts, even just £10 or £20 each month, can be enough to get started.
Aim to build an emergency fund that can cover three to six month’s worth of living expenses. Then, put these funds in a separate, but easily accessible bank account. This will help you avoid impulsive spending.
With an emergency fund, you can avoid unnecessary stress during an emergency, as you’ll have the funds to deal with it, allowing you to build financial resilience.
2) Budget and Review Your Monthly Expenses
To avoid getting trapped in debt, it’s important to examine where your money is going each month. Understanding and reviewing your expenses allows you to find areas where you can cut back and save some money. You don’t have to make huge sacrifices, but small changes will add up over time.
Knowing how to avoid debt traps becomes easier once you better understand your monthly expenses to eliminate non-essential spending. For example, making meals at home instead of eating out or limiting non-essential platform subscriptions.
Reviewing your expenses regularly helps you keep in control of your finances and will help you more effectively navigate financial emergencies.
3) Avoid Impulsive Spending
When you’re caught up in financial stress, many of us are guilty of making quick decisions, which often end up not being the right ones. However, impulsive spending, while tempting, often leads to unnecessary financial pressure.
During these moments, take some time to think things through before making a purchasing decision, especially if it’s not an essential expense. A good tip is to give yourself 24 hours before going through with your non-essential purchase as this will help you make a more informed decision.
Managing wants vs needs and practising more mindful spending habits will help you figure out how to better avoid debt traps and keep in control of your finances.
Choose Salad Money for Fair and Affordable Personal Loans
When learning how to avoid debt traps during a financial emergency, the hardest part is knowing how to limit yourself. While certain emergencies may require you to borrow money, using this money responsibly is essential.
With the above strategies, you can avoid falling into debt traps and more effectively manage your finances during an emergency.
At Salad Money, we recognise the unpredictability of financial emergencies and how they can often occur without warning. That’s why we offer fair and accessible personal loans to help you get through challenging financial times.
As a leading online UK lender, we help you access the financial support you need, when you need it. Our ‘More Than Your Score’ loans help you access the funds you need regardless of your credit score.
We use Open Banking technology to analyse your current financial situation and gauge loan affordability, instead of just your credit score. We’re an FCA-authorised organisation, so you can rest assured we’ll keep your financial information safe.
To learn more about our personal loans, click here, and to read more blogs like this one, visit our blog page now.
