- Get Out of Debt
Debt avalanche, also known as “debt stacking,” is a popular method and effective debt repayment strategy designed to reduce the total interest that you pay and to clear your debts quickly. It’s easy to implement and while it works best for borrowers with a lot of credit card debt, it can also help with student loan debt and secured debts.
What is the Debt Avalanche Method?
The avalanche method has one basic rule: Focus your money and attention on the debt with the highest interest.
Whether it’s a sizeable credit card balance, a car loan or a medical bill, this is the debt that demands the most money, has the most impact on your credit score, and places you at a greater risk. Once you clear this debt, your credit score will improve, you’ll have more money in your pocket, and you can then focus your attention on the next largest debt.
How to Use the Debt Avalanche Method
As with the debt avalance strategy and other debt payoff strategies, you should always meet your debt obligations. This means paying at least 100% of your minimum payments and not doing anything that will increase them. While you might be tempted to skip multiple payments and then use that money to repay the debt with the highest interest rate, this will do more harm in the long-run.
Instead, meet those monthly payments and increase the minimum payment on the debt with the highest interest rate. Use any extra money that you have to do this—every cent helps. Most of your minimum monthly payment goes towards the interest, but if you increase this, that extra money will chip-away at the principal, thus reducing the size of your debt and decreasing the term.
You will repay the debt quicker and pay less interest, keeping more money in your bank account and improving your credit score.
How Quickly Can You Pay off Debt with the Avalanche Method?
You can use a debt payoff calculator to understand exactly how quickly you’ll repay the debt. The interest rate, minimum payment, and debt size all need to be factored into the equation before you can calculate this figure.
However, while we can’t give you an exact timeframe, we can show you just how important it is to increase your minimum payment.
Let’s assume that you have substantial credit card debt ranging from 16% to 20% APR, including a credit card balance of $20,000 at 20%. Over 5 years, that debt will cost you approximately $11,500 in interest if you don’t make any extra payments. However, if you add just $100 a month to your minimum payment, you’ll pay nearly $3,000 less during the term and that term will be shortened by 14 months. If you can increase that to over $400 a month, you’ll repay the credit card debt nearly 3 years sooner and save over $6,500 in interest.
You’re paying more, but in doing so you’re saving more, and can use the money you save to clear other credit card debt, loan debt, car loan debt, and even your mortgage. Once your first debt clears, you’ll have more breathing space, more disposable income, and you can then focus on the next high-interest debt.
Should I Close Accounts When They Clear?
A palpable sense of relief washes over you when you clear a debt. Even if it’s just one of many, it’s still one less debt to worry about and it’s proof that what you’re doing is working. You need that milestone to mark your success and prove you’re on the right course.
However, it’s important not to close your credit accounts once they’ve been cleared. As tempting as it is to get them out the way, doing so will reduce your credit utilization ratio. This accounts for a huge 30% of your FICO Score, so it’s important to keep it in check. Credit utilization essentially compares all your debt to all your credit, rewarding you when your ratio is low and punishing you when it’s high.
You can improve this ratio by clearing your debt, as that means you have more available credit than accumulated debt. However, if you cancel those credit accounts, your available credit drops as well and you’re back where you started.
How Does the Avalanche Method Save You More Money?
The idea of spending more to save more seems a little counterintuitive, so how does this work and how can a debt repayment strategy like debt avalanche save you money?
To understand this, you need to understand how interest works. If you’re charged 20% interest on a debt of $10,000, that should mean a total repayment of $12,000 (20% of $10,000 + original loan = $12,000) over the year.
However, the interest is compounded, which means interest is added to interest, creating a cycle of debt. If that $10,000 debt with a 20% APR compounds every year, it will reach $12,000 in year 2; $14,400 in year 3; $17,280 in year 4, and so on. Of course, if you meet your monthly payment throughout that year then it won’t compound exactly as described, but it won’t reduce that much either.
Typically, your monthly payment will be 2% of the statement balance. In the above example, let’s assume that your interest payment is $166 (20% APR / 12 months). This brings your debt to $10,166 for the first month, 2% of which is $203. This means that 81% of your monthly payment is interest and every month your debt reduces by an insignificant amount.
The more you increase your monthly payment, the more of your money goes towards the principal and not the interest. Not only does this significantly decrease the payoff term, but it also decreases the balance the next time the interest compounds, which means you’ll pay less in interest as well.
Credit cards list their interest in the form of an annual percentage rate, but it’s actually calculated on a daily basis, so even paying an extra few dollars from one day to the next could reduce the total interest you pay.
This is why it’s important to pay more than the minimum every month and it’s why debt repayment strategies like debt snowball and debt avalanche are so effective. You can also look at balance transfer consolidation, where you move your balance from one card to another, taking advantage of a 0% introductory rate so that every monthly payment goes 100% towards the principal.
Tips on Making this Debt Repayment Strategy Work
To make the debt snowball or debt avalanche methods work, you’ll need to have some extra cash every month. That’s easier said than done, but there are some tips to help you:
- Tighten Your Belt: The average American family spends close to $3,000 eating out and wastes close to 40% of the groceries they buy. Budget better, eat out less, and you could save hundreds of dollars a month.
- Sell-Up: How many clothes do you have that you don’t wear? How many games, DVDs, CDs, and books do you have that are just gathering dust? It has never been easier to sell these things and you could earn a few bucks from doing so.
- Have a Garage Sale: If you’ve sold your media or don’t have anything to sell (if you’re younger than 25, there’s a good chance you’ve never bought a CD in your life) then have a garage sale instead. You’ll probably still have furniture, ornaments, and other tidbits you can sell.
- Cash Your Savings: It’s always good to have a rainy-day fund, but if you have masses of debt and no way to pay it, that rainy-day is here. If you’re still not convinced, use a savings calculator and a debt calculator and compare the two, seeing how much the savings will earn you versus how much the debt will cost you over the same period. You’ll likely discover that your money is better used to clear your debts.
- Embrace the Gig Economy: It has never been easier to freelance and if you have any spare time you can make between $15 and $100 an hour depending on your skill level. Sites like Upwork, Guru, Fiverr, and more are perfect for writers, designers, coders, and even people looking for a little admin work.
Debt Snowball versus Debt Avalanche Method
The debt snowball method focuses on repaying the smallest debts first. You can use a debt snowball calculator to understand how this will benefit you and then compare it to the same calculations on an avalanche method. Both will help you pay off debt and are heavily dependent on you finding extra cash every month, but the rate at which you clear debts and the amount you save will vary greatly from one repayment method to the other.
Take a look at our article on the Debt Snowball Method vs the Avalanche Method to read our deep dive on this topic.
Summary: How do You Know Which Method is Right for you?
Now that we’ve covered the debt avalanche method extensively, just one question remains: How do you know which debt payoff strategy is right for you? Will you be better suited to hitting those high-interest rates first, or should you focus on the debt snowball method and grab those low-hanging fruits?
If you’re the sort of person who struggles to focus on the bigger picture and needs the frequent willpower boosts that regular debt clearances will bring, then the debt snowball method may be the better option. If you have the perseverance to make it to the end and never to flounder, then the avalanche method will likely save you more money.
The important thing is to find a suitable debt reduction strategy, place additional funds toward your minimum payment and to make sure you’re always moving forward. Debt snowball and debt avalanche are just different ways of doing the same thing, which is putting more money towards your debts to reduce interest and pay off debt quickly.
Source: pocketyourdollars.com