What Is a Debt Avalanche?
A debt avalanche is a type ofaccelerateddebt repayment plan. Essentially, a debtor allocates enough money to make the minimum payment on each source of debt, then devotes any remainingrepayment funds to the debt with the highest interest rate. Using the debt avalanche approach, once the debt with the highest interest rate is entirely paid off, then the extra repayment funds go toward the next-highest interest-bearing loan. This system continues until all the debts are paid off.
Key Takeaways
- The debt avalanche is a systematic way of paying down debt to save money on interest.
- Individuals who use the debt avalanche strategy make the minimum payment on each debt, then use any remaining available funds to pay the debt with the highest interest rates.
- A debt avalanche is different from a debt snowball, which is when a borrower pays down the smallest debt first.
How Debt Avalanches Work
Paying off your debts can be a daunting task, especially when you're faced with multiple debts, high balances, and sky-high interest rates. Making only the minimum monthly payments each month can make the process seem even more overwhelming, as the majority of your payments go toward interest rather than the principal balance.
This is why it's important to have a strategy in place that will help you become debt-free. Using the debt avalanche strategy is just one possibility. This tactic allows you to concentrate on the debts with the highest rates first. You can then target the one with the second-highest rate until you're left with the one that charges the lowest rate.
The debt avalanche allows you to focus on lowering the debt you have by paying less interest over time. Here's how you should structure the strategy:
- The first step in starting a debt avalanchestrategy is to make a list of all the debts you owe along with the individual interest rate for each.
- Next, designate an amount of your available monthly incometo pay debts. This amount should come from any fundsnotcurrently obligated for living and household expenses such as rent, grocery, daycare, ortransportation.
- Make a lump-sum payment (above the minimum payment) to the debt with the highest interest rate. Ensure that the payment is significant but within your means.
- Continue making minimum payments on your other obligations until the highest debt is clear.
- Move on to the debt with the next highest interest rate until all your debts are clear.
This strategy takes time, so it's important to be patient and not lose your focus.
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Advantages and Disadvantages of Debt Avalanches
As with any strategy, there are benefits and drawbacks that you must weigh out before you begin tackling your debts. We've highlighted some of the key pros and cons of using a debt avalanche strategy to pay off your debts below.
Advantages
The advantage of the debt avalanche method is that it reduces the total interest you pay in the long term. Interest adds to your debts because most lenders usecompound interest.The accrual rate depends on the frequency of compounding—the higher the number ofcompoundingperiods, the greater the compound interest.
A debt avalanche repayment strategy also reduces the amount of time it will take you to get out of debt—assuming you make consistent payments—because less interest accumulates.
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Disadvantages
One of the main disadvantages of using the debt avalanche as a repayment strategy is that it only targets interest rates rather than balances. As such, you may not necessarily put a dent in the debt with the highest balance as it only receives the minimum payment. This can be daunting and seem as if you're not making any progress.
The debt avalanche method requires discipline for consistency, which can be a downside for some people. Even with the best intentions of sticking with the debt-avalanche system, you may revert to making minimum payments on all the debts, especially if your financial situation changes. That’s why most financial planners recommend that people first save up a six-month emergency fundbefore attempting any accelerated debt payoff plan.
Pros
Reduces total interest paid
Less time to get you out of debt
Cons
Targets interest rates rather than (high) balances
Requires discipline and consistency
Debt Avalanche vs. Debt Snowball
The debt avalanche is different from thedebt snowball. This is another accelerated debt payoff plan that involves a focused, dedicated approach.
With the debt snowball strategy, the debtor uses money beyond the minimum payments to pay off debts with the lowest balance first before moving on to the one(s) with the largest outstanding balance.
This means that you pay more than the minimum payment on the debt with the lowest balance until it's paid in full. Then, move on to the next lowest until you eventually reach the one with the highest balance. As with the debt avalanche, you must continue making the minimum payments on the other debts as you knock off the smallest one in the bunch.
Although the debt snowball method does not save as much as the debt avalanche in terms of total interest charges, it can offer more motivation by eliminating small debts more quickly.
Most credit card balancescompound interest daily, but there are loans where the interest can compound monthly, semi-annually, or annually.
Example of a Debt Avalanche
Here's a hypothetical example to show how a debt avalanche works. Let's say you have$500 available every month (after you factor in your living expenses) to put toward paying down your debt. Say your currentloans include:
- $1,000 on acredit card with a 26%annual percentage rate (APR)
- $1,250 on a personal loan with 12%
- $5,000 line of credit (LOC)with an8%interest rate
For simplicity’s sake, assume each debt has a minimum monthly payment of $50. You would need to allot $150 toward paying each loan's minimum monthly payment ($50 x 3). The remaining $350 would also be put toward your credit card, the highest-interest debt. After that you would put the extra money toward the personal loan until it is paid off. Finally, you would put all $500 toward your line of credit, which has the smallest interest rate.
What Is an Example of Debt Avalanche?
An example of using debt avalanche can help illustrate how it works. Say you had three credit cards and were carrying balances on each. The first credit card had a $600 balance with an APR of 24%, the second credit card had a $1,000 balance with an APR of 26%, and the third credit card had a $1,200 balance with an APR of 19%. Using this method, you would first pay down the second credit card because it has the highest interest rate.
What Is the Difference Between the Debt Avalanche and the Debt Snowball?
A debt avalanche method of paying off debt is paying off the debt with the highest interest rate first. With a debt snowball method, you focus on paying your extra money toward your smallest debt first. The advantage of the debt avalanche method is that it saves more in interest in the long term, and the advantage of the debt snowball method is that it can be more motivating.
What Is the Disadvantage of Debt Avalanche?
The major disadvantage of the debt avalanche method of paying off you debt is in cases where your highest-interest debt is also your largest debt. If you start putting your extra money toward paying down this debt first, you may save money on interest, but you may not feel like you are making strides toward paying down the loan.
The Bottom Line
Whether the debt avalanche or the debt snowball method is best strategy to pay off debt will depend on you. Using the debt avalanche method will save you the most money in interest in the long-term, but some people find more success with the debt snowball method, which can be more motivating because you pay off a debt sooner.
