Debt causes stress for millions of people, and working to cover even simple minimum payments can be hard. Paying down big balances or eventually regaining more financial freedom are intimidating goals for many. The stress debt causes can even impact your health.
The best way to get debt-free is to develop and implement specific strategies to prioritize your debt payoff. Ideally, the strategy should focus on tactics that lower payments and help free up more cash.
To reduce credit card debt and student loan debt, financial experts have devised many debt repayment strategies. One method, discussed in another blog post, is how the Debt Snowball method works to pay off debt. The snowball method means paying off your smallest debt amounts first.
Another repayment strategy is the Debt Avalanche method. Read on to find out how this debt reduction strategy works, who should use it and how it could improve your personal finance and credit habits.
How the Debt Avalanche Method works
The Debt Avalanche method prioritizes debt repayment by addressing debts with the highest interest rate first. With this method, you focus on making extra payments or making a regular monthly payment that’s greater than the minimum amount due. Either method encourages you to put a portion of any extra cash – like tax returns or bonuses – towards your debt payments too.
While applying more money to the debt with higher interest rates, make minimum monthly payments on the other debts on your list. Once you pay your debts with the highest interest rate, it’s time to focus any extra money on the debt with the next highest interest rate. Continue on this payoff plan until you pay off all your debts.
The math behind the Avalanche Method
At first, it may seem like the snowball debt repayment method is more effective because it encourages you to pay off smaller credit card debts right away. It may feel more manageable and efficient to address a $500 debt than to address a $5,000 debt with a high interest rate first.
And, if you have trouble getting and staying motivated to pay off your debts, studies have shown that the Debt Snowball method can be the most effective.
However, the math behind the avalanche method accounts for the fact that credit card interest compounds. That means the longer you let a balance sit on a credit card, the more the interest you owe grows.
Let’s say you have a credit card balance of $5,000 with a high interest rate of 26%. Interest compounds quickly and creates an even larger debt. That total interest amount could end up being twice as much as the original principal balance.
By addressing the debts with the highest interest rates first, you slow the compounding and lower the overall total interest you pay over time. This approach could save you hundreds, if not thousands of dollars, over time.
Who should use the Debt Avalanche Method?
Anyone who has debt should consider using this repayment method. People who have credit card, personal loan, payday loan debt, or other debts with high interest rates should definitely look into this strategy.
You can also use it for any other type of loan repayment included in your total debt.
At the end of the day though, the best debt repayment strategy for you is the one that keeps you motivated to pay off your debts and improve your financial health.
What the Debt Avalanche Method doesn’t do
This payoff method doesn’t involve tactics like debt consolidation or loan forgiveness. Instead, this debt repayment strategy focuses solely on tackling each debt individually and ensuring everything is repaid according to the original terms.
Get your credit back on track
While using the debt avalanche method, keep your credit score in mind. Many factors impact that score, including your debt-to-credit ratio. This weighs how much of your credit you spend versus how much credit you have available.
Typically, your credit utilization rate should be below 30% on each credit card or line of credit you have if your goal is to build credit. That means if your credit limit is $1,000, then your credit card balance should be below $300. Though, when it comes to your credit score, the lower your credit utilization, the better.
When you focus on eliminating debt with the highest interest rate, that may leave other credit cards close to maxed out. Don’t be surprised if this causes a drop in your credit score. This dip is only temporary and tends to go away as you pay off more debt.
Going forward, try to maintain the best credit utilization ratio possible. Pay down credit cards to zero if possible. Always be aware of how much you’re spending on those cards versus how much you have available to pay off the debt.
Getting your payment plan in place is an important first step to start tackling your debt. Once you start paying down your debt, it’s important to get your plan in place for staying out of debt after you pay it off too.
Learn more about how to decide which debts to pay first in the post “How to Prioritize Debt Payments.”