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The Debt Avalanche Method Explained

If you’ve heard of the debt avalanche method, you might be confused as to how it differs from the debt snowball method. Maybe you’re facing a mountain of debt, and you’re looking at how to pay it off with the least amount of struggle.

Debt interferes with daily life and costs us freedom financially. You know you need to pay off your debt, and you’ve been trying to avoid bankruptcy and credit counseling programs.

The problem is, most of the common information you’ve heard about paying off debt seems to ignore one thing: the interest rate.

While the snowball method instructs you to list your biggest debt first and disregard interest, the avalanche method takes a more mathematical approach.

Here’s what both debt management plans have in common: They require that you:

  1. Stop Borrowing Money. You can’t pay off debt if you’re still taking out loans and buying things with credit. You’ll need to cut your budget down to a cash-only plan by reducing expenses.
  2. Have Laser-Focus on Debt. Cancel everything that gets in the way of paying off your debt. This means you don’t invest in stocks, you don’t take an expensive vacation, and you don’t decide to remodel the house. All spare cash goes into your debt program.

Ultimately, the best method is the one you’re more likely to stick with, but you’ll need the details to make an educated decision. By the end of this article, you’ll have a good explanation of the debt avalanche method and whether it’s right for you.

How the Debt Avalanche Method Works

The idea of the debt avalanche method is simple. You place the highest-interest debt at the top of a list and pay them off first. Meanwhile, you make minimum payments to all other creditors at the same time. This way, you minimize the rate of interest accrual by deprioritizing the lower interest debt.

When you pay off your first debt, you give yourself a pat on the back and move your focus to the second debt on the list. You then use the amount that you were paying on the first debt and add it to the second.

If you keep following this method, you’ll have eventually tackled the entire list while paying minimal interest to your creditors.

The main benefit of this method is that you are saving money because you’re paying less interest. The avalanche method will be the perfect plan for you if you can’t stand high-interest rates and giving too much money to your creditors.

You’re likely to have success with the avalanche method if you are:

  • You’re not swayed by short-term gratification or emotional purchases. You’re in it for the long-haul, and you know that if you stay on track, you’ll come out ahead.
  • Detail-Oriented. You make good decisions when you have the facts and numbers at hand. Keeping track of personal finances is a numbers game that you can win if you do your calculations correctly.
  • Tactical and Deliberate. You can’t stand throwing more money at your creditors than they deserve. With a smart plan and solid follow-through, you can save money and pay off debt quicker.

Let’s take an example list of four debts. We’ll say that you are willing to throw in an extra $999 more than the minimum payments each month to pay off debt. Here are the four debts using the debt snowball method:

Debt Snowball Method

The Debt:

Debt A: $4,569 for a car loan with a 6% interest rate and $435 monthly minimum payments.

Debt B: $11,859 in personal loan debt with a 7.6% interest rate and $315 monthly minimum payments.

Debt C. $12,119 in credit card debt with a 16% interest rate and $300 monthly minimum payments.

Debt D. $163,845 in school loans with a 4.750% interest rate and $770 monthly minimum payments.

The Results:

Debt Total (Principal): $192,392

Monthly Payments Total (Minimum Payment of $1820 plus an extra $999): $2819

Payoff Date: February 2024

Interest Paid: $34,429.49

The total amount of interest paid was $34,429.49 with the snowball method. Not pretty. Let’s check the avalanche plan.

Notice that Debts A, B, and C are switched according to highest interest first in the list below:

Debt Avalanche Method

The Debt:

Debt C. $12,119 in credit card debt with a 16% interest rate and $300 monthly minimum payments.

Debt B: $11, 859 in personal loan debt with a 7.6% interest rate and $315 monthly minimum payments.

Debt A: $4,569 for a car loan with a 6% interest rate and $435 monthly minimum payments.

Debt D. $163, 845 in school loans with a 4.750% interest rate and $770 monthly minimum payments.

The Results:

Debt Total (Principal): $192,392

Monthly Payments Total (Minimum Payment of $1820 plus an extra $999): $2819

Payoff Date: February 2024

Interest Paid: $33,660.79

See the difference? The total time to pay off the debt stayed the same when comparing the two methods, but the interest paid changed.

The interest on the avalanche method is not pretty either, but paying off the debt in the debt avalanche order would have saved you a total of $768.70 in interest payments.

The results can be more extreme if you have several high-interest rate loans. Sometimes the debt avalanche method can shave off a few months from repayment time too.

Using an Excel spreadsheet will allow you to add a new sheet for each month so you can go back to check progress quickly and see how far you’ve come.

Conclusion

Using the debt avalanche method can save you money and time in paying your creditors. It might take you longer to pay off the first debts on the list than if you’d used the snowball method, so there is no quick emotional gratification. But knowing that you’re minimizing interest payments to your creditors may be just as rewarding.

Ultimately, the goal is to pay your way to financial freedom by choosing the best debt plan that works for you.

How Does APR Work?

If you have ever taken out a loan for a mortgage, automobile, education, or some personal reason, then you should know what an annual percentage rate (APR) is. At any rate, most people understand that it is some sort of charge on top of the loan. Despite that general concept, a ton of people don’t really understand how it works, and less than enough people seriously take APR into consideration before signing up for a loan. With that said, I am going to cover one of the most basic considerations that need to be made when you are shopping for different APRs on any sort of loan you may or may not take out. I’ll cover some basics by jumping right into it!

What is APR?

As mentioned earlier, APR stands for annual percentage rate. If it sounds completely foreign to you, then just think of it as an interest rate for now even though it is technically different. APR is how the banks and lenders make money! They offer a loan to a consumer and they tack on this APR. Each month, that APR defines how much you will owe in interest on top of the principal balance. For those who do not know, a low APR is preferable to a high APR. Higher APRs mean you’ll end up paying more in interest over the life of your loan.

How Does It Work?

Well, here is a quick run around on how APR works. The annual part means it is calculated over the year despite being applied every month. This is where many people (at least some of the people I’ve talked to) get confused. If you have a 12 percent APR, you will be charged 1 percent interest each month; at the end of the year, that amounts to your 12 percent APR. You will NOT be charged 12 percent each month! It isn’t technically an interest rate because it is taken as a percentage over the year; it’s APR! Despite that distinction, these two terms are used interchangeably all the time. Just know that APR is divided up by twelve months out of the year, and each month you are charged that much in interest each month on your remaining principal balance on the loan.

Typical APRs to Expect

So APRs are defined by whoever is issuing the loan, credit card, or anything else involving interest. These companies rely on an underwriting system that is heavily dependent on credit score, or in other terms, they take into account your credit history when deciding how much money they want to try and charge you each month.

If you are considered a high-risk consumer, that means you do not have a good credit history (just a reminder, having a bad credit history means you’ve struggled to pay your debts on time in the past among other things of course). If you are a high-risk type of person who misses payments from time to time, then you are going to receive a higher APR. Think of it this way. You have a high APR, and you’re terrible at paying your bills on time. The lender is going to make a fortune off of you eventually. Despite that cynical thought, the high APR may actually be meant to discourage you from borrowing a loan in the first place! These last couple of ideas are just some of my ideas, but it remains true that those with unworthy credit generally receive higher APRs.

What is the Difference between a Variable and Fixed APR?

So let’s say you are in the market for a new loan. You need to figure out what annual percentage rate (APR) you want before signing the dotted line. By figuring out what APR you want, I mean you need to decide whether you want a variable rate or a fixed rate on your loan. They definitely aren’t the same thing! Despite being big and bad financial terms, it is easy to understand what they are and how they differ from each other.

APR Basics

So let’s cover a few basics about APR before moving forward. An APR is calculated over the entire year, but it is applied monthly. This means that if you had a 24 percent APR, then you are charged 2 percent each month. The APR defines how much interest you are going to owe from the last month, and that interest amount is tacked on to your principal balance. Well, there is a small lesson in interest payments right there. It wasn’t all inclusive, but it works for this article.

What is a Variable APR?

So here is a quick spoiler: variable APRs change or vary with time. How do they change exactly? Well, they are dependent of the fluctuation of the market. So look at it this way with my quick, cheap example. One year you get a loan with a variable APR of 2 percent because interest rates are low in the market overall. After five years with the loan, you notice that your APR has now doubled to 4 percent. This is because you picked the variable rate, and it is subject to change depending on the market. That scenario sounds awful, but it’s a two-way street, meaning your interest rate could decrease over the same time period. Think of it as a gamble of sorts.

I keep mentioning the market, but I haven’t explained it yet. There is this rate that all of the big banks and groups lend to each other in the stock market. It may differ in name from market to market, but generally, there is a base rate that the big dogs base their rates on. In the United States, the Federal Reserve sets this base rate. All of the lenders tack on basis points (another term for percentage basically) to this rate. There you have it.

What is a Fixed APR?

A fixed APR is a much simpler horse to handle. Like a variable rate, a fixed rate is determined by the market at the start of the loan, but instead of changing over time, it remains fixed at that rate upon disbursal of the loan. It offers more certainty than a variable rate loan because there is no risk of your rate increasing later on, but there is less potential to save on interest down the road.

What’s the Difference?

One of them changes and one of them doesn’t! A fixed rate offers more certainty by keeping the rate stable, but it leaves out the potential for a reduced rate later. A variable rate offers the potential for a lower rate later on, but it’s also much riskier than a fixed rate.

Why You Should Apply for a Balance Transfer Credit Card

When discussing the uses for, benefits of, and reasons behind applying for a balance transfer credit card, a little bit of context is required. So money is tight, and you have a ton of credit card debt. Boom. There’s half the scenario right there, but there’s one crucial aspect this scenario yet to be said. You have all of this debt, and you can’t handle it all that well. But on top of that, you have a credit card (or multiple cards) with a high annual percentage rate (APR).

That’s the scenario we are working with here. You have an APR, or sometimes referred to as an interest rate despite being technically different, that is simply too high, and as you struggle to make monthly payments, interest starts accruing on top of the debt you already have. In a nut shell, your credit card debt is growing, and you can’t stop it.

So this leads us to the solution and topic of this article that was mentioned earlier – apply for a balance transfer credit card. There is one basic reason for doing this, and it revolves around handling your debt more easily and stymieing the growth of interest on top of your principal debt.

Get a Lower Interest Rate & Save Money

If you didn’t know, you can transfer debt from one card to another, hence the term balance transfer. There’s only one reason for doing this, and that is to secure a lower interest rate. So I literally just mentioned that you want to stymie the growth of interest. Logically speaking, if you are having trouble covering each monthly payment, then you need a lower interest rate for this to happen. This is where balance transfer credit cards come in!

When most people apply for balance transfer credit cards, they are trying to take advantage of some variation of a 0 percent balance transfer APR offer. Typically, a card will offer 0 percent APR on any balance transfer to that card for any period ranging between 6 to 21 months. This means you don’t accrue interest on the act of a balance transfer which is really only possible when there is an introductory offer for balance transfers. In short, it costs money in interest to transfer debt from one card to another, and the recently mentioned introductory balance transfer APR of 0 percent cuts that out of the equation.

So you save money with a low cost or no cost balance transfer. Then theoretically and hopefully, you will have transferred your debt to a credit card with a lower APR. So every month, less interest will build on top of your principal balance, and you should have an easier time paying back your debt.

There are a couple of limitations to this strategy of course. Most importantly, applying for a balance transfer credit card requires a credit card application. When you apply for a credit card, you get your credit pulled which means the card issuer is evaluating your credit history. There’s a chance that you may not have the required credit history to qualify for a new card. In short, if your credit is bad, then you may get rejected, even if it might help you pay back debt!

The Benefits of Student Loan Refinancing

This day and age, a large majority of college students have incurred some form of student debt; in fact, most sources put the figure at 70 percent of college students, totaling an overall $1.4 trillion in student debt. That’s a huge number! So basically, there are tons of college kids taking out student loans for higher education.

The student debt picture is a bit of a hot topic today, mainly due to the fact that a decent number of people are not paying back, or struggling to pay back, their student loans. Well, debt isn’t a new concept, and there are plenty of measures and financial services in place to help people manage their debt.

The financial service of the day right now happens to be refinancing, and in this particular case, we’re discussing the benefits of student loan refinancing. Here are a few of the standard and common reasons for deciding to refinance your student loans.

Obtain a Lower Interest Rate

So what’s the number one reason why you would refinance your student loans? To get a better interest rate! Student loans are generally offered with two different kinds of interest rates: fixed or variable. Variable rates fluctuate with the market, but fixed rates remained fixed throughout the life of your loan. Let’s say you have a fixed rate. Ten years down the road, you may find yourself with an interest rate that doesn’t reflect the current market rate. And that’s where refinancing comes in! If you qualify for student loan refinancing (refinancing is offered by private lenders), then you can essentially trade out one or multiple student loans (both federal and private) for one single loan with a new interest rate. Depending on your creditworthiness, you can get a lower rate and save money on interest over the life of your loan.

Simplify Monthly Payments

Many students are forced to take out multiple student loans during their college career. This can lead to a confusing monthly payment situation down the road. If you have both private and federal student loans, then it can get quite tricky. You could have multiple payments due at different times of the month, and you could get either overwhelmed or just annoyed at the whole process. Well, when you refinance your student loans, you are also consolidating them into one single loan. That means one payment once a month. Sounds pretty simple!

Pay Down Multiple Forms of Debt – The Smart Way

When you have multiple debts, it can seem impossible to keep up with the minimum repayments, let alone make headway. In some cases, just $1,000 on a credit card can take almost 25 years to pay down if you are only making the minimum payments. To get ahead of your debts, you need to know how much you owe, what the minimum repayments are, and what the interest rate is. Once you know that, you can look at tackling your debts head on.

Define the Problem

Step one to crushing your debts is to define the problem. While you might know that you owe $50,000 across various loans and credit cards, this information won’t help you to get ahead. Sit down and go through all your payments until you can make yourself a list of exactly how much you owe, who you owe it to, and when they expect to be paid. Then find out the interest rates for each debt and you should end up with a list something like this:

  Owing Min. Monthly Payment Interest Rate Time to Repay
Credit Card #1 $5,000 $100 20% 9 years
Credit Card #2 $800 $25 13.25% 3 years
Car Loan $12,000 $250 7.99% 5 years
Personal Loan $10,000 $150 4.59% 7 years

 

In this example, you need to make minimum repayments of $525. Over the life of the loans you will be paying over $10,000 in interest. To shorten this term, go over your budget and see how much extra you can put towards different sources of debt. Even $100 a month could save you thousands.

Approach Repayments with your Head, Not your Heart

Now that you have defined the problem, there are a few approaches you could take. You can put a little extra into each loan, pay down the smallest balance first, or pay down the debt with the greatest interest rate first. First, consider whether a balance transfer credit card suits your needs. If you cannot find a way to lower your rates, then start tackling debt with the highest interest rate first. While you might want to start with the smaller debts, knocking down the high interest ones will save you the most money over the life of your debt.

In the above example, if you start by paying down the 20 percent APR credit card debt, you will save $3,481 and knock more than six years off of repayment. Once that card is paid, you will have another $100 a month free that you can put towards closing out your second card.

When you have paid down your credit cards, you will have approximately two years left on the car loan. Take the $225 a month from your credit card repayments and put it towards your car loan. You’ll shorten the loan by a year and save close to $300.

Finally, take $340 a month from your other loan repayments and tackle your personal loan. The increased repayments will knock two years off the life of the loan.

By snowballing your debt repayments starting with the highest interest rate, you can cut both the repayment time and the total interest paid in half. While it might seem like a daunting place to start from, every dollar makes a difference, and once you get started momentum picks up quickly. Just like in this example, the first step is the hardest, and the first debt takes the longest. Despite this, by you’ll see your debts rapidly melt away by sticking to a solid plan.

Why You Need a Budget

One of the hallmarks of being a ‘responsible adult’ is knowing where your money goes. Many people get through their lives without ever writing down a firm budget. They are comfortable knowing that slightly more money comes in than goes out, and they might be able to comfortably manage a holiday once or twice a year. However, many more people spend more than they earn. This causes problems, but this is where budgeting comes in and saves the day.

Why budget when the money is flowing?

Waiting until you are in strife to budget is like planting your crops mid-winter when starvation sets in – starting early on a budget when the weather is nicer ensures a good harvest for the year. By setting a good budget early you may find that you have more or less money than you originally thought. With a budget, you can start saving before you have goals. This will mean less waiting and less strife when you decide to pursue a big ticket item, like a mortgage deposit or a round the world extravaganza.

Budgeting: Tricky and boring?

The first hurdle you may face when budgeting is apprehension. Budgeting has a reputation for being complicated, time-consuming, and downright boring. Budgets are viewed as setting rules to deprive yourself of spending; however, it all depends on your approach. Methods like the zero-sum budget focus on giving all of your dollars a job, including saving. By making this decision to save at the start, you don’t need to hold back money ‘for savings’. Simply divert money into savings on payday and do whatever you like with the rest.

For a more detailed budget, break up what you spend into the biggest and most important categories: housing, transport, food, fun, and ‘other’.  Give yourself a rough estimate on your spending and review your efforts at the end of the month. Once you know where your money is going, you can adjust your budget (or your spending) to suit your goals. If you find too much money disappearing into the ‘other’ column, create a new column that suits you. Maybe it’s ‘travel’, maybe it’s ‘pets’, or maybe you need an entire column devoted to ‘wine.’ Your choice!

The Bottom Line

Budgeting isn’t about setting rules and sticking to them. It’s about taking control of your spending so that you can make informed choices. Tools like You Need a Budget or Pocketbook can help do the heavy lifting for you by categorizing your expenses and telling you exactly how much you saved each month; however, you do have to give them access to your bank details. For something a little more hands on, try out the Money Smart budgeting tools, or even the household budget template in Google Sheets.

Once you have a budget in place, you can start planning where to spend next. Budgeting helps you dig your head out of the sand and look to the future. Whether you’re aiming for a round the world trip, a deposit for a new home, or owning the world’s most expensive dog, having a budget puts you in control.

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