Latest posts by Kumiko Ehrmantraut (see all)
- How to Use Dollar Cost Averaging to Build Wealth - September 17, 2020
There a thousand different ways you can get into debt, but there are only really two ways to pay it off. The debate on which method to use has been around for a very long time and in my opinion, there is no right answer.
How you decide to start paying off debt depends on your individual circumstances and how your mind really works. It's a personal choice that needs to be made in order for you to create an effective plan to tackle your debt.
WHAT IS THE DEBT AVALANCHE METHOD?
This type of debt repayment plan, also known as debt stacking, allows you to repay your debts in the shortest amount of time and will save you the most money on interest. The debt avalanche method targets the debts with the highest interest rates first. Once the debt with the highest interest rate is completely paid off, you use extra funds to tackle the next highest interest rate debt on the list.
HOW IT REALLY WORKS
For example, let's assume you have three debts you are trying to pay off.
- $1,000 credit card debt (annual interest rate = 20%)
- $5,000 car loan (annual interest rate = 6%)
- $5,000 credit card debt (annual interest rate = 21%)
To make things simple for the example, let's assume the minimum payment for each debt is $50. If you have a total of $500 every month that you can use to pay down debt, $150 of that will go towards covering your minimum payments. That means you have an extra $350 every month to apply towards paying down your debt.
With the debt avalanche method, that extra $350 would go towards debt #3 because it has the highest interest rate. That means you would be paying a total of $400 ($350 extra funds + $50 minimum payment) towards debt #3 until it was completely paid off.
Once debt #3 is completely paid off, the extra payment would go towards paying off debt #1 because it has the second highest interest rate. That means you would be paying a total of $450 ($400 extra funds + $50 minimum payment) towards debt #1 until it was completely paid off.
Finally, once debt #1 is completely paid off, you would then put all $500 towards the last remaining debt, which in this example is debt #2.
- Related: How to Create a Plan to Pay off Debt
WHO SHOULD USE THE DEBT AVALANCHE METHOD
The debt avalanche method is best for people who are patient and more analytical. If you support the mathematical reasons for paying off debt, such as saving on interest, then this method is for you.
If you are a person who needs instant gratification then this method is not for you. It might take you longer to pay off each individual debt but your debt as a whole will get paid off more quickly.
BEFORE YOU GET STARTED
In order to decide how much money you have to use for debt repayments, you first have to calculate your monthly expenses. Creating a budget will allow you to see how much you can dedicate towards implementing the avalanche debt payoff strategy.
If you are working with limited income and a tight budget, I highly suggest that you start using the Cash Envelope Method for budgeting. I have written a detailed guide on how to create a budget using this method that you can read HERE.
Any extra income that you come across outside of your normal budget should be used to pay off your priority debt.
STEP #1: ORDER YOUR DEBTS FROM HIGHEST INTEREST RATE TO LOWEST
You will probably find that credit cards are on the top of your list. Most of the time credit cards or store cards have interest rates that range from 20%-25% or higher. When prioritizing your debts, make sure you use the rate you're actually paying, not what it will be after any promotional period ends.
You will also need to record the minimum payment for each debt. This will allow you to see how much extra you can put towards your debt avalanche strategy after covering minimum payments. Add up all of your minimum payments and then figure out how much extra money you have by using your budget. This can be found by subtracting your income from your expenses. If you have a positive number, that is the amount of extra money you have to begin to get rid of your debt.
If you end up with a negative number after you subtract your income from expenses, look for areas in your budget where you can cut back. For example, get rid of cable and get services such as Sling TV, Philo, Netflix or Hulu. Find ways to save on gas by taking advantage of public transportation or carpool with a spouse. Look for areas in your grocery budget where you can save money by using apps such as Ibotta.
Your account balances are not used in the debt avalanche method. The main things to focus on is your interest rate and your minimum payments.
Step #2: START MAKING PAYMENTS
You will still need to pay the minimum payment for each debt. It's important that you make your minimum payments on time so you avoid late fees and increases in your interest rates. Pay all minimum payments except for the one debt listed at the top of your Debt Worksheet.
The debt listed at the top of your Debt Worksheet is the debt you are going to put all extra cash towards. If you are currently putting money aside for saving, I do recommend that you either suspend or reduce that amount in your saving budget until you eliminate your high-interest debt. You will be able to save more by getting rid of high-interest debt than they would from actually putting a set number aside for savings.
To recap, you will still pay the minimum payment on all other debts except for the debt listed at the top of your Debt Worksheet. All unused income after paying for expenses should be dedicated towards the debt account with the highest interest rate (Debt priority #1).
Step #3: REPEAT EVERY MONTH
By making the minimum payments to every creditor, you ensure all of your debt obligations are being taken care of but you focus only on your debt with the highest interest rate. Once you have paid off your first priority debt, reorder your debts and start the process over. Make sure to consistently check your interest rates for changes, especially if you are on a promotional period that offers 0% interest.
When you are ready to move on to your second priority debt, take the minimum payment and the extra funds you were using to pay off priority debt #1 and apply it to priority debt #2.
For example, if you were paying a minimum payment of $50 and extra funds of $100 towards debt #1, when that debt is paid off you will apply $150 extra funds to pay off debt #2 plus debt #2's minimum payment.
FREE RESOURCES
You can always create a worksheet like the one provided in this article to track your progress using the debt avalanche method, or you can use an online resource to track things for you.
There are two online resources that are completely free that I recommend.
The excel spreadsheet from Vertex is one that I have personally used and love. It's also available in OpenOffice and Google Sheets. With these spreadsheets, you can choose which debt reduction strategy you want to use. You simply need to choose the debt avalanche method from the drop-down box after you enter your creditor information into the worksheet. I highly suggest your watch the demo video as well. I was a little overwhelmed when I first downloaded the template but after watching the video things were a lot easier.
The other free resource I suggest checking out is NerdWallet's Debt Payment Plan Calculator. Unlike Vertex's spreadsheets, this calculator is completely automated in real-time. You simply enter your login credentials for each creditor into their 256-bit encrypted dashboard and it will give you a plan that shows exactly when you will be out of debt. It's great because if you need to make changes to your payments, their system makes it really easy to see how it will affect your overall plan.
Creating a plan and the process of paying off debt is not an easy task. Don't forget to celebrate the small wins along the way. For every $500 of debt that I paid off, I celebrated my success with my husband and family. I also kept track of how much debt I was paying off by creating a fun giant size thermometer that my son and I would color in along the way. Setting and achieving short-term goals, like paying off $500 worth of debt, will give you the motivation to continue on your debt repayment journey.
Have you used the debt avalanche method to tackle debt?
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