Sweep Away Your Debt With a Debt Avalanche
People who are deep in debt often wonder how exactly they got there. Most consumer debt — credit cards especially — accrues slowly over time. When people go to the grocery store and end up with a larger than expected bill, they swipe their credit card. When they go to the movies and gripe about spending $50 on popcorn and candy and soda for two people, they swipe their credit card. When their car breaks down and they have to pay for necessary repairs, they swipe their credit card. Soon enough, all those swipes add up. People suddenly find themselves staring down a $10,000 balance and a $300 minimum monthly payment.
One of the best ways to tackle debt works in the exact opposite fashion from the slow, glacial pace at which the debt accrued. It's designed to pay down debt as fast and efficiently as possible, an ever-quickening, ever-growing financial cascade. After all, what's the best way to get rid of a glacier of debt? The answer is…
THE DEBT AVALANCHE
Debt usually comes from many different sources, just like a massive river is fed by smaller tributaries. There are credit cards and auto loans, personal loans, and medical bills, all adding up to one large, seemingly-insurmountable hunk of debt.
Except that those smaller sources of debt are important to distinguish from each other. One of the most frustrating parts of debt is that it's constantly growing due to the interest being charged. But not all interest rates are the same. Some are higher than others.
By making the debts with the highest interest rates a priority, you can pay down your debt faster and ultimately save more money than you would by paying them all off at an equal rate. This focus on interest rates, rather than the principal, is the key to the Debt Avalanche. It's what distinguishes it from the Debt Snowball, which was covered in a previous post.
To best illustrate how the Debt Avalanche works, let's use the same example that we used to illustrate the Debt Snowball: a 100% hypothetical guy named Bill. When Bill tallied all of his loans and credit cards together, he discovered that he had $44,500 in debt. This was negatively affecting Bill's credit score, so he decided to start paying off all his debt immediately. In the previous post, Bill used a Debt Snowball. Let's see how things would have been different if he had used a Debt Avalanche.
Bill began by organizing all of his debts in ascending order from the highest APR to the lowest. (It's best to use APR instead of just the interest rate because the APR will factor in any additional fees that are charged.) His spreadsheet looked something like this:
|Name of Loan
After trimming his spending back, Bill was able to set aside $2,000 a month for debt repayment. As he was already spending $1,161.58 per month on the minimum payments, this left him with an extra $838.42 per month to start paying off his debt.
Bill started with his Visa Card because it had the highest interest rate: 19%. He added the $838.42 to the $77.50 monthly minimum he was already paying for a total of $915.92. The principal on the Visa Card was $3,000. Four months later, it was $0.
Bill then moved on to his personal loan, which had an interest rate of 15%. He took the $838.42 in additional money plus the $77.50 Visa Card monthly minimum that he was no longer paying and added it to the $322.00 monthly minimum for the personal loan. In total, he was now paying $1,237.92 toward the personal loan's $8,000 principal. It took him seven months to pay it off.
Continuing in this fashion, it took Bill eleven months to pay off his Master Card, only one month to pay off his Macy's Card and eight months to pay off his car loan. All in all, Bill went from $44,500 in the hole to entirely debt-free in 31 months. That's just over two-and-a-half years.
With the Debt Snowball, it took Bill 32 months to pay off all his debt. Now, one month might not seem like a huge difference, but, remember, he was paying $2,000 every month. Shaving off just that one month saved him $2,000.
The argument in favor of the Debt Snowball, made by people like financial guru Dave Ramsey, is that it gives people easy and early "wins" that encourage them to keep going. This is true. However, the math clearly favors the Debt Avalanche method as the fastest and cheapest way to get out of debt.
Maybe it helps to think about it like this: what would you rather show up to a snow fight with? Would you rather have a snowball or an avalanche?