Debt Trap

Debt Trap
A debt trap is a situation in which a borrower is led into a cycle of re-borrowing, or rolling over, their loan payments because they are unable to afford the scheduled payments on the principal of a loan. These traps are usually caused by high-interest rates and short terms.

What is a Debt Trap?

Debt traps are circumstances in which it is difficult or impossible for a borrower to pay back money that they have borrowed. These traps are usually caused by high interest rates and short terms, and are a hallmark of a predatory lending.

How does a Debt Trap work?

Any time a person borrows money from a professional lender—whether it’s a loan or a line of credit—there are two basic elements to the loan agreement. First, there is the loan principal: the amount of money that the person has borrowed. Second, there is the interest: the amount of money that the lender charges on the principal.

Paying back borrowed money means paying back both the principal and the interest. Paying back the principal is especially important because it’s the only way that a borrower makes progress towards paying off the loan in full. Many installment loans come with amortizing structures, which means that the loan is designed to be paid off in a series of regular, fixed payments; each payment applies toward both the principal and the interest.

A debt trap occurs when a borrower is unable to make payments on the loan principal; instead, they can only afford to make payments on the interest. Because making payments on the interest does not lead to a reduction in the principal, the borrower never gets any closer to paying off the loan itself. It’s pretty similar to a hamster on its wheel: running and running but staying in the same place.

The amount of interest charged on a loan will vary depending on several factors, including the creditworthiness of the borrower, the type of loan being issued, and the general health of the economy. The borrower’s creditworthiness is a very important factor, as people with a good credit score can usually qualify for better loans at lower interest rates. People with bad credit, on the other hand, will be often be saddled with higher rates and less favorable terms on the few loans they are able to get. This is why people with poor credit are generally at a very high risk for debt traps.

What other features can lead to a Debt Trap?

Three of the most important features that can lead borrowers into a debt repayment are short repayment terms, lump sum repayment, and loan rollover. Oftentimes, all three of these features will appear on the same loan.

Some loans are designed to be repaid in a month or less. This means that the borrower has very little time to come up with the money to pay both the interest and the principal. These loans are also usually designed to be repaid in a single lump sum. Many borrowers, especially those with low incomes and poor credit ratings, have difficulty raising the necessary funds to pay the loan off all at once.[1] (This is why your typical installment loan does not require lump sum repayment. Instead, they are structured to be paid back in a series of regular, fixed payments.)

When customers are unable to pay these loans back on time and in full, they are usually given the option to rollover the loan. This means that the borrower pays only the interest owed on the loan and, in return, is given an additional repayment term. However, this new term also comes with an additional interest charge. In essence, the borrower is being charged additional interest on the same principal loan amount. And since the repayment terms on these loans are often very short, they are not being given that much more time to pay the loan back. This can lead to borrowers rolling the loan over repeatedly, paying only the interest owed without every paying down the principal.

Are there different kinds of Debt Traps?

There are several different types of loans and lines of credit that can all too easily turn into a debt trap. The three most common types are payday loans, credit cards, and title loans.

Payday Loans

Payday loans are also called check loans or cash advances. These loans work by advancing money on someone’s paycheck, government benefits, or other guaranteed deposit. In most cases, the borrower gives the lender a postdated check for the amount of the loan plus interest.

These are short-term loans, with an average term length of only 14 days.[1] The interest rates for payday loans are generally in the range of $15 per $100 borrowed. However, due to their short terms, a simple interest rate of $15 per $100 borrowers adds up to an Annual Percentage Rate (APR) of 390 percent. (The APR measures how much a loan would cost if it were outstanding for a whole year.)

Payday loans are meant to be repaid in a single lump sum, which can be very difficult for many borrowers, especially given the short repayment terms. In fact, the average payday loan customer can only afford to pay $100 per month on their loan, despite owing an average of $430.[2]

When a borrower rolls over their payday loan, the lender charges an additional interest fee to extend the loan for another term. A full 75% of all payday loan business comes from rollovers, resulting in $3.5 billion taken from mostly low-income consumers every year. The average payday borrower stays in debt for 212 days per year.

Credit Cards

Credit cards are a line of credit that can lead to a potential debt trap due to their revolving balances. Lines of credit are loan products in which the borrower is not given a lump sum of money; instead, they are given a maximum credit that they can borrow up to. When a line of credit is said to have a revolving balance, it means that the line’s available funds replenish as the borrower pays down the outstanding balance. For example: if a borrower has a credit card with a $2,500 credit limit, spends $100 of that limit, then pays off that $100, they still have a full $2,5000 available to them.[3]

With credit cards, the cardholder does not necessarily have to pay off the outstanding balance off all at once. They can pay it off with smaller payments over time, but that will mean that the outstanding balance will continue to accrue interest each month. Most credit cards also have a monthly minimum payment amount that the cardholder has to pay. However, this minimum amount is usually very small. Paying the card off while making only the minimum payment could take many years and cost the cardholder thousands of extra dollars in interest.

Credit cards also carry a lot of extra fees that can lead to an increased amount of debt and higher monthly payments. Fees such as late payment fees, over credit limit fees, balance transfer fees, rate increases for late payments can all increase the amount owed. If a borrower is already behind on their payments for their credit card, these fees can make the card even harder to pay off.

Car Title Loans

Title loans are short-term, cash loans that use the title to the borrower’s vehicle as collateral. (Collateral is a term for valuable property offered by the borrower in order to “secure” a loan. If the borrower is unable to pay the loan back, the lender gets to seize the collateral to make up their losses.) The principal amount of the loan will depend on the value of the borrower’s vehicle; however, lenders will generally only offer a borrower between 25 and 50 percent of what their car, truck, or motorcycle’s actually worth.[4]

Most title loans are structured to give borrowers about 30 days to pay the loan back, including the interest.[5] The average interest rate for a title loan is 25 percent per month, which adds up to a 300 percent APR. It is common for these loans to be rolled over (80% of title loans are issued as a part of a multi-loan sequence).

If a borrower is unable to pay back their loan, the lender can then repossess their vehicle. One in five title loan borrowers end having their car repossessed. Some states have laws that force lenders to pay borrowers the difference if they have sold their car for more than what they owed. However, other states allow lenders to keep the difference.

References

  1. Gerenger, T. “Why You Should Never Use a Payday Loan.” MoneyNation.com. Accessed Aug 2, 2016. https://moneynation.com/never-use-payday-loan/
  2. Bourke, N., Horowitz, A., & Roche, T. “Payday Lending America: How Borrowers Choose and Repay Payday Loans.” PewTrusts.com. Accessed Aug 2, 2016. https://www.pewtrusts.org/~/media/assets/2013/02/20/pew_choosing_borrowing_payday_feb2013-%281%29.pdf
  3. Roos, D. “How Revolving Credit Works.” Money.com. Accessed Aug 2, 2016. https://money.howstuffworks.com/personal-finance/debt-management/revolving-credit1.htm
  4. “Single-Payment Vehicle Title Lending.” ConsumerFinance.com. Accessed Aug 2, 2016. https://files.consumerfinance.gov/f/documents/201605_cfpb_single-payment-vehicle-title-lending.pdf
  5. Neiger, C. “Why Car Title Loans are a Bad Idea.” CNN.com. Accessed Aug 2, 2016. https://www.cnn.com/2008/LIVING/wayoflife/10/08/aa.car.title.loans/index.html?iref=24hours