"Do you want to build a snowman...during an avalanche?" - The Debt Avalanche Payoff Method
So last week, we discussed a method to paying off your debt known as the Debt Snowball Method. This week we are upping the personal finance ante. Snowballs are safe, but what about an avalanche sort of mentality to paying off your debts. Let's go!
What's this method all about?
So again, I want you to picture yourself outside in the snow. This time though, you're at the top of a snowy hill about to build your debt snowman. You pack snow into a ball and you begin to roll that snowball around to build it to the size of the base of the snowman. But because you're at the top of a hill, the ball of snow begins rolling downhill, picking up speed, and getting large fast. That's the idea of the Debt Avalanche Method. The debt avalanche method involves paying off your balances with the highest interest rates first. This plan prioritizes financial efficiency and is one of the cheapest ways to get out of debt.
Arrange all of your debts by interest rate, from highest to lowest (Remember to budget enough to cover the minimum monthly payment for every debt). Every month, put the extra money you budgeted for getting rid of debt toward your debt with the highest interest rate. Once the debt is repaid, take the entire amount you were paying toward it (monthly minimum plus your extra money) and target the next highest interest rate debt.
Pretend you have the following debt:
Credit Card 1 - $2500 (@ 13.5%): Monthly payment $65
Credit Card 2 - $3000 (@ 19.8%): Monthly Payment $85
Student Loan 1 - $7000 (@ 5%): Monthly Payment $80
Student Loan 2 - $5500 (@3.5%): Monthly Payment $70
Medical Bill - $500 (interest free); Monthly Payment $45
Using the debt avalanche method, you would put them in the following order, paying off credit card 2 first. This time, we ignore balance and focus on interest rates.
1) Credit Card 2 - $3000 (@ 19.8%): Monthly payment $85
2) Credit Card 1 - $2500 (@ 13.5%): Monthly payment $65
3) Student Loan 1 - $7000 (@ 5%): Monthly Payment $80
4) Student Loan 2 - $5500 (@3.5%): Monthly payment $70
5) Medical Bill - $500 (interest free); Monthly Payment $45
Now that we have the debt in order, let's say using your budget, you see you have an extra $50 to put towards these debts. You would begin paying $135 a month toward credit card 2 ($85 original payment plus the $50 of extra income). Once credit card 2 is paid off, you take the entire monthly payment of $135 and tack that on to Credit Card 1, so the new monthly payment is $200 (original $65 plus the $135). The benefit of this method is that you limit the effect of high interest rates charged while you pay down all your debt. By paying less interest on your balances, you get the balances down faster, costing you less money in the end.
I think this method is good if you are focused on saving total out of pocket costs when paying off your debt. This method takes more commitment and focus on the end goal. The debt snowball method focuses on small victories during the process, while the debt avalanche method focuses on a huge victories at the end (debt gone and I paid the least amount of interest to do it).
Whichever method you pick, remember this is your plan and you have flexibility. Just pick one and watch your debt disappear, kinda like trying to find a snowman in an avalanche :)