What is a Debt Avalanche?

debt avalancheDebt avalanche is a type of accelerated debt payoff plan.

Specifically, a debtor allocates enough money to make the minimum payment on each debt, then devotes any remaining debt-repayment funds to the debt with the highest interest rate. Using the debt avalanche method, once the debt with the highest interest rate is entirely paid off, the extra repayment funds go toward the next highest interest-bearing loan. This method continues until all the debts are paid off.

The first step in employing a debt avalanche approach is to designate the total amount of monthly income available to pay debts. This amount is any funds not currently obligated for living expenses such as rent, grocery, day care, or transportation expenses.

As an example, imagine you have $500 available every month after paying for living expenses to put towards debt payoff. Your current loans include:

$1,000 due on a credit card debt with an annual interest rate of 20%,
$1,250 monthly car payment at a 6% interest rate, and a
$5,000 line of credit (LOC), with an 8% interest rate

For simplicity’s sake, assume each debt has a minimum monthly payment of $50, except for the car loan, where the minimum payment would be the regular monthly installment.

You’d need to allot $100 toward paying each debt’s minimum monthly payment ($50 x 2). The remaining $400 would add to the money devoted to your highest-interest debt. In this example, you’d pay a total of $450 toward settling the credit card debt charging a 20% interest rate. The card debt will be entirely paid off by the fourth month, assuming no additional charges added to the card balance. Now, the extra funds would go toward retiring the second-highest interest-bearing debt, the line of credit. Finally, all $500 would go to the debt with the lowest rate of interest, the car loan.

Debt Avalanche Reduces Interest But Takes Discipline

The advantage of the debt avalanche is that it minimizes the amount of interest you pay while working toward your debt-free goal, as long as you stick to the plan. It also lessens the amount of time it takes to get out of debt, assuming constant payments, since less interest accumulates.

Interest adds to these debts because lenders use compound interest rates. The rate at which compound interest accrues depends on the frequency of compounding such that the higher the number of compounding periods, the greater the compound interest. Most credit card balances will compound interest on a daily basis, but there are loans where the interest can compound monthly, semi-annually, or annually.

The disadvantage of the debt avalanche is that it takes discipline and commitment to pull off. It is easy to revert to making minimum payments on all the debts, especially after unforeseen expenses like auto or home repairs. That’s why most financial planners recommend people first save up a six-month emergency fund before attempting any debt payoff accelerator plan.

Different From a Debt Snowball

The debt avalanche is different from the debt snowball, another accelerator plan. In a debt snowball, the debtor uses money beyond the minimum payments to pay off debts from the smallest balance to the largest. Although this method will it costs more, in the total amount of interest charges, the debt snowball method does motivate with the elimination of some small debts.

 


 

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