What is the Debt Avalanche Method?
- December 2, 2016
- Posted by: Jeff Gitlen
- Category: Personal Finance
Consumers looking for ways to pay off their debt will find there are many methods to do so. Among those methods is the debt avalanche, also sometimes referred to as debt stacking. This method may appeal to you if you have a sufficient amount of income to support your basic expenses and payments at the same time. To say the least, it requires a bit of planning and due diligence to pull off.
Consumers who are patient and analytical are often the most suitable candidates for this method. Here is the basic idea of how it works. You restructure your debt payments by ranking debts based on priority. Debts with the highest interest rate are ranked first, so you prioritize by interest rate.
While other methods of paying off debts involve paying off the highest balances or even the lowest balances first, there is one major benefit to paying off your debts with the highest interest rates first. If you choose to do so, you can reduce the overall cost of your loans.
While you could attempt to negotiate your interest rate with your credit card companies, that approach may not always work. The debt avalanche method allows you to eliminate your highest-interest debt successfully before tackling the rest. Setting this priority allows you to focus on the most detrimental and effective portions of your debt.
A major incentive behind the debt avalanche method is to counteract capitalization. For those who do not know, capitalization happens when interest is added to the total remaining balance at the end of the month; that addition then becomes part of the overall principal balance. If you were to theoretically let that new balance carry over next month, then interest capitalizes on the larger principal balance. This leads to accelerated growth of debt if not handled correctly.
This is a problem for many consumers who have trouble managing debt from mortgages, personal loans, student loans, credit cards, or any other debt with an interest rate.
In summary, by devoting more money towards the debt with higher interest rates, you will be able to lower your balance much faster, thus bringing down the overall amount of interest paid to your creditors. Most consumers find that the debt avalanche method actually accelerates loan repayment, which is positive for one’s net worth.
How to Get Started With the Debt Avalanche Method
Prior to getting started with this method, you will need to gather all of your monthly financial obligations. If you have never taken the time to sit down and determine exactly how much debt you owe, then this step can be an eye-opening experience. It can also be somewhat frightening.
One of the goals of this step is to determine whether you can realistically pay off your unsecured debt in five years or less. If you find that it simply is not realistic to do so, you may want to consider debt relief options. With that disclaimer aside, most people are able to pay off their debt by simply adhering to a strict budget. Incorporating your income and debt into a budget is the first step towards outlining your debt avalanche approach.
Start your budget by listing all forms of debt with their associated interest rates. Next, rank the debts in order of highest to lowest interest rate. After that, write down the minimum payment for each of your debts. Even if you have been paying more than the minimum on some of your debts, write down just the minimum payment. Add up all of the minimum payments to get an overall monthly debt expense.
With the debt segment out of the way, list out and sum up your other monthly expenses such as cable, electric, groceries, gas, or any other subscriptions and utilities. Now all your monthly expenses (debt and extra) are covered. Afterwards, list out all sources of income after taxes.
Take the difference between your monthly expenses and monthly income to calculate your discretionary funds. With all of your ducks in a row, you can determine how much extra you can devote to paying off debt.
Whatever number you come up with is to be put towards the highest interest debt until it is paid completely. Here is where the avalanche part comes in! After the first debt is paid off, you combine the extra debt payment with the minimum from the paid-off debt. This gives you a new extra debt payment which is subsequently applied to the next debt obligation down the line!
Note: If you want to find out how much you can save on a specific loan or credit card by making extra payments towards it, check out our Debt Repayment Payoff Calculator!
As you work your way down the list, you may find that the process gets faster. In some cases, it can go slowly if interest outperforms the additional funds going towards your debt. Keep in mind that you should keep track of any interest rate changes. An alteration to a rate will definitely affect your strategy.
You may find it helpful to use a spreadsheet for tracking your progress as you pay off your debts. This is also a good way to keep your motivation high and continue knocking out debts, especially if your highest-interest rate debt also happens to be your largest debt.
Now you know about debt avalanche! It takes a bit of work and time, but it ultimately helps you manage multiple forms of debt without having to rely on any desperate financial measures.