When we talk about retiring a debt, your strategy can spell the difference between success and failure. If you don’t have one, chances are, you’ll head to failure. But those who have created a debt repayment plan know exactly how much extra cash they can pay towards their debts and what debt is on the top of their list. Your plan will motivate you and will optimize your chance of becoming debt-free as fast as possible.
You’ve heard about the debt snowball method. There’s another method to pay down your debt that you might not have heard about. It is the debt avalanche method and it can wipe off your debt once and for all.
What’s the Debt Avalanche Method?
The principle for the debt avalanche method looks at the burden that the debt interests place on the borrower and prioritizes their payment.
For example, you pay off the credit card from the highest interest rate to the lowest rate no matter what their balances are. Doing this allows you to lower the amount of each payment that just goes to interest at a faster pace compared to a debt snowball scheme.
Interest that keeps on building up makes it really hard for you to get out of debt. Zeroing on this debt can help you address this issue and register some visible progress. With the debt avalanche method, you can save money on interest and pretty soon, you’ll be wiping off your credit card balance in no time.
How to Use The Debt Avalanche Method
A debt avalanche works this way: You try to get a quick win upfront by retiring the one with the highest interest rate. The debt snowball method will try to retire the one with the smallest balance first and does not mind the interest rates at all.
1. Create a list of all your debts and arrange them in a repayment order from the highest interest rate to the lowest interest rate. Disregard the balance of each one for this list.
2. Keep paying at least the minimum payments on all your debts but prioritize paying off the one with the highest interest rate first. Then, you move on to the next one on the list, and so on until you have repaid everything. The only thing that will vary over your repayment time is how much you will pay toward the debt that’s first on your list.
3. As soon as you’ve crossed out the first debt on your list, add that debt’s minimum monthly payment to the minimum monthly payment of the next debt on your list. This will cause you to pay more every month on this debt and eventually, you’ll be able to pay it off too. Continue the method until you’ve paid off all your debts, like in our example where you can pay 3 debts over time.
4. Do this month after month. After some time, you’ll be able to pay off the first debt on the list. Once done, move towards putting extra money (plus the first debt’s minimum payment) towards the second debt on your priority list.
When it comes to debt repayment, the debt avalanche method is the most cost-effective and causes you to pay less interest and have a faster repayment timeline.
The other option is the debt snowball method where you pay the one with the smallest balance first even when it has the lowest interest rate. This method is a good motivator because it feels good to pay off one of your debts totally. But the disadvantage is that you may end up paying more interest over the years.
The Debt Avalanche Example
Let’s look at a simple illustration. Let’s assume that you have 4 existing debts with the amounts $500, $400, $200 and $100. When you use the snowball method, your strategy would be to pay off the smallest debt first. But in the debt avalanche method, you pay off the debt with the highest interest rate burden first. Therefore, the order of payment would be something like:
- 1: $500 (25% interest rate, $25 minimum payment)
- 2: $200 (20% interest rate, $10 minimum payment)
- 3: $100 (15% interest rate, $5 minimum payment)
- 4: $400 (10% interest rate, $20 minimum payment)
Let’s say that you have set a budget of $170 for debt payment every month. In month one, you would be able to meet the minimum payments to debts #2 to #4 (a total of $35). Your remaining $135 would all go to debt number 1, taking care of the minimum $25 and an additional $110.
Continuing this pattern, you would retire debt #1 in month 4. You can then continue paying the minimum payments to debts #3 & #4 but you will use the money you’ve freed up to pay deb #2 (minimum plus whatever is left on the budget). You would continue with this process until eventually, all your debt payment budget will go solely for the full repayment of debt #4.
The Debt Avalanche Pros And Cons
Pro: The most important advantage of the debt avalanche method is that it will pay off your debt in the fastest time possible.
This is most helpful in saving you tons of money when you have big debts with high interest. You can save more with this method compared to the snowball method.
Con: It’s a long process and maybe psychologically challenging
Depending on your personal financial situation (your debts, balances, interest rates and debt repayment budget), the debt avalanche method can take a long time. It may take years to pay off even a single debt – imagine all the work you need to do!
If you don’t see yourself being able to chip off a portion of the same exact debt little by little every month, then this method is not for you. A spreadsheet might be helpful to track your progress or maybe a debt payoff calculator can help you zero in on a workable strategy.
Con: It requires high motivation.
This method works best for people who have a high motivation to get out of debt and who can face multiple setbacks. This is also more appropriate for those who incurred their debts due to unusual circumstances.
The debt avalanche method works best when your debt with the biggest balance happens to be the one with the highest interest rate too. If the one with the highest interest rates is the smallest loans, this method doesn’t make much of an impact.
Eventually, it is up to you to make the choice. On one end, there’s the debt snowball method which has proven itself to be effective in helping people stay on track on their debt repayment challenge. On the other end, there’s the debt avalanche method that has a mathematical backing to show that it’s cheaper for you. The decision is up to you.
Math will tell you that the debt avalanche method is the way to go. But it doesn’t necessarily mean that it’s the best method to retire your debts. If you ultimately decide that the debt avalanche method is for you, find ways to stay motivated and on course. You can set small goals for yourself and celebrate their achievements (without spending money) to mark your milestones.