Using Debt Avalanche Strategy to Get Out of Debt
Have you heard about debt avalanche before? What does debt avalanche mean and how does it work? I will explain all these to you in this article. Even if you don’t know anything about debt avalanche before, I believe that by the time you are through with this article in a couple of minutes, you will have a better understanding of the subject.
What is debt avalanche?
Debt avalanche is a strategy one can use to pay off his debts whereby the debt with the highest interest rate is paid first before attention is directed to other debts with lower interest rate. Of course, debt avalanche is not the only strategy that you can use to pay off your debts. There is another strategy called debt snowball. Debt snowball means arranging your debts in the order of the amount involved and paying the least debt amount first. Debt snowball strategy can be good for people who are being weighed down by debt burden and don’t even know where to start the payment from. Paying first the least debt amount serves as motivation that other debts can equally be paid. Before I go to explaining debt avalanche, let me illustrate how debt snowball works.
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How debt snowball works
Let’s assume that you have the following debt profile. Credit card balance on first card is $2,500; credit card balance on second card is $600; medical bill $1,200; student loan debts $25,500 while auto loan stands at $8,000. If you want to use debt snowball strategy, your attention is not about the interest rate you are paying on the debts. In this case, you simply focus on the debt you can easily and quickly pay off. And that will be your second card balance of $600. What this means is that you will only make minimum payments on all the loans while you direct the excess amount you have left to pay the debt with the least amount, which is your second card balance. You will continue this process until the debt with the least amount is fully paid. Once this is done, you simply repeat the process by directing your attention to the second least amount in your debt profile. From the above information, your second least debt is medical bill of $1,200. For clarity, if you want to use debt snowball strategy to pay off your debt, you will arrange the debts mentioned above in this order.
Credit card 2: $600
Medical bill: $1,200
Credit card 1: $2,500
Auto loan: $8,000
Student loan debts: $25,500
The good thing about debt snowball is that, as you succeed paying off the first least debt, you feel motivated to pay the next one. For instance, by the time you finish paying off the second credit card balance, you will no longer have five different debts. Your debts would have gone down to four in number. This is more manageable and less strenuous.
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How does debt avalanche works?
Debt avalanche is somehow very close to debt snowball. The difference here is that, instead of ranking your debts based on the amount of each debt, you will rank the debts based on their interest rates. The debt with the highest interest rate will be ranked first and then followed by the debt with the next highest interest rate. For illustration, let’s still use the same information we used above to explain how debt snowball works except that we are striking out the medical bill here. So, we shall assume that your debts are credit card balance on first card is $2,500 with interest rate of 15%; credit card balance on second card is $600 with interest rate of 12%;; student loan debts $25,500 with interest rate of 7%; while auto loan stands at $8,000 with interest rate of 10%.
If you want to adopt debt avalanche approach in paying off the debt, the debts will be arranged as follows:
Credit card 1 @ 15% $2,500
Credit card 2 @ 12% $600
Auto loan @ 10% $8,000
Student loan debts @ 7% $25,500.
The rationale behind using debt avalanche strategy is that you will be able to save some interest by ensuring that the debt with the highest interest rate is paid first. This will also help you ensure that you pay your debts fast as your payments will not just be going toward financing the interest element of the debt. Once you have paid the debt with the high interest rate, more of your payments can be directed to paying down the principal of other debts.
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Please note that using debt avalanche strategy does mean abandoning other debts. You will still need to continue making minimum payment on other loans on time every month so that you are not penalized for late or missed payment.
You may then want to ask that, between debt avalanche and debt snowball, which is better? I will say that it depends on individual’s situations and circumstances. If you want a sort of encouragement or motivation, you might consider debt snowball strategy. With debt snowball, you can quickly pay off the debt with the least amount. This will encourage you to pay the off the next debt. On the other hand, with debt avalanche strategy, you will be able to save money on interest and you may be able to pay off the debt faster as the principal amount tend to reduce faster.