The debt avalanche method is a loan repayment strategy, that focuses on paying off the highest interest debts first. The debt avalanche strategy effectively reduces any borrower’s overall debt cost.
Here’s how you can apply the debt avalanche method to repay the loans:
- Start by listing all your debts, including credit cards, loans, and other outstanding balances.
- Arrange the debts in order of interest rate, from highest to lowest (descending). The debt with the highest interest rate should be at the top of the list.
- Make the minimum required payment on all debts each month to avoid penalties and keep all accounts in good standing.
- Allocate any extra money you have each month to the debt with the highest interest rate.
- Once the highest-interest debt is paid off, move to the next debt on the list (the one with the next highest interest rate) and apply the same strategy.
Example of avalanche method
Let’s say you have the following debts:
- Credit Card A: $5,000 balance at 20% interest
- Credit Card B: $2,000 balance at 15% interest
- Student Loan: $10,000 balance at 6% interest
- Car Loan: $8,000 balance at 5% interest
Now, list the loans in descending order (keep the highest interest-bearing debt first).
The list would appear like the below:
- Credit Card A: $5,000 at 20%
- Credit Card B: $2,000 at 15%
- Student Loan: $10,000 at 6%
- Car Loan: $8,000 at 5%
Make the minimum payments of all debts:
- Credit Card A: $100/month
- Credit Card B: $50/month
- Student Loan: $150/month
- Car Loan: $200/month
Suppose you have an extra $300 to put towards your debt each month. So, you need to allocate the extra money for the payment of your most costly loan.
Your payment strategy would be:
- Pay the minimum on all debts: $500 total ($100 + $50 + $150 + $200)
- Use the extra $300 to pay off Credit Card A, the highest-interest debt.
Once Credit Card A is paid off, move to the next highest-interest debt, Credit Card B.
This means you will be paying $50 (minimum) + $400 (extra from Credit Card A) = $450 for the credit card B.
When does the debt avalanche strategy become applicable?
The avalanche method is effective for borrowers having multiple bad loans such as more than one credit card with heavy outstanding. Per the avalanche method, the borrower can prioritize high-interest debt and adopt a disciplined financial approach.
In a nutshell, the debt avalanche strategy is best applied when you:
- Have debts with varying and particularly high interest rates.
- Can consistently apply extra payments toward debt repayment.
- Are motivated by long-term financial savings rather than short-term victories.
- Have a stable financial situation and understand the mechanics of interest rates.
However, the debt avalanche strategy is not suitable for someone in need of a psychological boost who needs to lower the number of loans.
Below are the situations where the debt ava;anche method practically gets effective:
If you have multiple debts with varying interest rates, particularly if some have high interest rates, the debt avalanche strategy is very effective for minimizing the total interest paid. As a result, the borrower can create extra savings for another repayment. This method is also applicable to debt relief programs when counselors try to reduce the most costly loans over 4-5 years of time.
Similarly, if a borrower has multiple long-term debts, the avalanche strategy helps to determine which loan to pay first. As a result, overall debt management gets economical.
Furthermore, if you are disciplined and motivated by the prospect of saving money on interest rather than needing the psychological boost of quick wins (as provided by the debt snowball method), the debt avalanche strategy is ideal.
Also, someone needing financial stability rather than a quick win should follow this strategy. It reduces financial strain when you can consistently apply extra payments toward the highest-interest debt.
How does the debt avalanche differ from the snowball method?
Both the debt avalanche and the snowball method prioritize the debt payment per the borrower’s need.
If a borrower wants an economical solution, indicating lowering the overall debt management cost, the avalanche method is just perfect.
On the flip side, the debt snowball strategy focuses on paying off the smallest balance first to reduce the number of loans so that the borrower gets a psychological boost and stays motivated.
In a nutshell, the debt avalanche method is an economical strategy and the snowball option is a psychological relief method.
According to the Kellogg School of Management, while the debt snowball method (paying off the smallest balances first) can provide psychological motivation, the debt avalanche method is considered the “rational” strategy for minimizing interest costs and reducing overall debt faster.
What are the pros and cons of the debt avalanche method?
The avalanche method saves time and money; however, cannot offer immediate psychological relief from the existing debts.
The avalanche strategy requires patience, steady income, and financial discipline so that the borrower can focus on repaying the costly loans first.
There are positive sides to the debt avalanche method:
- Minimizes the total interest paid over time.
- More of your payments go toward the principal, reducing overall debt faster.
- The most economical way to pay off debt is when considering long-term costs.
These are the negative sides of the avalanche strategy:
- Can be harder to stay motivated, as initial progress might seem slower compared to methods that offer quick wins.
- Requires careful tracking of multiple debts and their interest rates requires adequate knowledge and skills.
- Needs consistent extra payments towards the highest-interest debt, demanding financial discipline.
How does the debt avalanche method affect credit score?
Performing the avalanche method while debt management can have a positive impact on credit score by reducing credit utilization, making on-time payments, and lowering the total debt. But, having a high balance on the high-interest debt or, a hard inquiry resulting from balance transfers may temporarily downgrade your score.
Theoretically, as you pay down high-interest debts, your overall credit utilization ratio decreases, which can positively impact your credit score. Credit utilization is a significant factor in credit scoring models, and keeping it below 30% is generally recommended.
Moreover, consistently making on-time payments, a key part of the debt avalanche method, positively affects your payment history, which is the most significant factor in your credit score.
Similarly, by focusing on paying off high-interest debt faster, you reduce your overall debt burden, which can improve your creditworthiness over time.
However, If you have high balances on the highest-interest debts, your credit utilization might initially remain high. Also, if you open new lines of credit or loans to facilitate the debt avalanche method, such as balance transfer credit cards, hard inquiries can temporarily lower your credit score.
Should you apply the debt avalanche method or consolidate loans?
Deciding between applying the debt avalanche method or consolidating your loans depends on your specific financial situation. You should execute the avalanche method when you have high-interest debts, you can stay motivated for a long time without taking further loans and you are comfortable with managing multiple loans.
However, the debt consolidation is applicable when:
- You struggle to keep track of multiple payments and need a simpler payment structure.
- You can qualify for a consolidation loan with a lower interest rate than your current debts.
- You want a fixed repayment schedule to help with budgeting.
In summary, debt consolidation simplifies your multiple debts into a single one and the avalanche strategy suggests paying the costly loans first.
How to make additional savings?
You need to make additional savings if you want to repay the most costly loan first. To get extra money each month, you need to set your financial goal and prepare a budget followed by expense tracking as well.
Here are a few tips that will help you make more savings to repay your loans fast:
- Use budgeting tools or apps to create and stick to a monthly budget.
- Regularly monitor your spending to ensure you stay within your budget and avoid unnecessary expenses.
- Cancel subscriptions and memberships you don’t use frequently, such as streaming services, gym memberships, or magazines.
- Contact service providers to negotiate lower rates on bills like cable, internet, and insurance.
- Evaluate your cell phone usage and consider switching to a more affordable plan or provider.
- Plan meals ahead of time, make a shopping list, and stick to it. Use coupons, buy generic brands, and shop sales to reduce grocery bills.
- Wait 24 hours before making non-essential purchases to determine if you need them.
- Consider refinancing high-interest loans to lower interest rates, which can reduce monthly payments.
- Focus on paying off high-interest debt first to reduce interest payments over time.
- Explore side gigs or freelance work to earn extra income in your spare time.
- Sell items you no longer need, such as clothes, electronics, and furniture, on online marketplaces.
- Set up automatic transfers to a savings account each month to ensure you consistently save money.
- Regularly review your financial goals and adjust your savings strategies accordingly.
The bottom line
The debt avalanche method is suitable for one who wants to minimize the overall interest amount. Anyone seeking a quick-win motive should follow the snowball approach.
