Definition of a Debt Trap

Debt is a problem for many people.

Debt is a fact of life for many people and corporations, and a certain amount of debt is normal and not financially unhealthy. However, some people cannot repay their debts, causing a damaging cycle of borrowing known as a debt trap.

Definition

A debt trap is a situation in which an entity borrows money, but does not have enough money to make the interest payments on the loan, so it takes out another loan--with its own interest payments--to cover the first loan's payments. They will likely have to borrow again to pay off the second loan, creating a crippling cycle.

Parties

Any entity that needs money can fall into a debt trap. This includes individuals, companies and countries.

Consequences for Individuals

Individuals that fall into a debt trap will find themselves harassed by collection agencies and unable to save any of their money unless they get a significant pay increase. Personal bankruptcy is one way to get rid of debt, but it can make any future borrowing, such as for a house or a car, difficult. Also, a bad credit score can also keep a person from getting an apartment.

Consequences for Companies

For companies caught in a debt trap, they either have to ramp up earnings and cash flow to pay their debts or they will go bankrupt. Investors often will not buy stock in companies with too much debt because the danger of bankruptcy and liquidation is high. This makes the situation even more difficult for public companies caught in a debt trap.

Consequences for Countries

Countries caught in a debt trap must encourage growth to increase revenues, or they will not be able to pay their bills. The International Monetary Fund often helps failing countries, but they have to accept difficult and unpopular economic policy changes to get relief funds.

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