What Is a Debt Avalanche?
A debt avalanche is a type of accelerated debt repayment plan. Essentially, a debtor allocates enough money to make the minimum payment on each source of debt, then devotes any remaining repayment funds to the debt with the highest interest rate. Using the debt avalanche approach, once the debt with the highest interest rate is entirely paid off, then the extra repayment funds go toward the next-highest interest-bearing loan. This system continues until all the debts are paid off.
To be successful, before embarking on the debt avalanche program, you should have enough money in the bank for both living expenses and emergencies.
How Does a Debt Avalanche Work?
The first step in launching a debt avalanche program is to designate an amount of your monthly income that is available to pay debts. This amount should come from any funds not currently obligated for living expenses such as rent, grocery, daycare, or transportation.
For example, imagine you have $500 available every month, after living expenses, to put toward paying down your debt. Your current loans include:
- $1,000 on a credit card with a 20% annual percentage rate (APR)
- $1,250 monthly car payment at a 6% interest rate
- $5,000 line of credit (LOC) with an 8% interest rate
For simplicity’s sake, assume each debt has a minimum monthly payment of $50, except for the car loan, where the minimum payment would be the regular monthly installment.
You would need to allot $100 toward paying each loan's minimum monthly payment ($50 x 2). The remaining $400 would add to the money devoted to your highest-interest debt. In this example, you'd pay $450 toward settling the credit card debt with the 20% interest rate. Assuming you do not add additional charges to the balance, the credit card debt would be paid off entirely by the fourth month. Now, the extra funds would go toward retiring the second-highest interest-bearing debt, the LOC. Finally, all $500 would go to the debt with the lowest rate of interest, the car loan.
The Debt Avalanche Reduces Interest but It Takes Discipline
Advantages of the Debt Avalanche
The advantage of the debt avalanche method of debt repayment is that it minimizes the amount of interest you pay while working toward your debt-free goal, as long as you stick to the plan. It also lessens the amount of time it takes to get out of debt—assuming consistent payments—because less interest accumulates.
Interest adds to these debts because lenders use compound interest rates. The rate at which compound interest accrues depends on the frequency of compounding such that the higher the number of compounding periods, the greater the compound interest. Most credit card balances will compound interest on a daily basis, but there are loans where the interest can compound monthly, semi-annually, or annually.
Disadvantages of the Debt Avalanche
The debt avalanche is a technique that takes discipline and commitment to pull off, so can be a clear disadvantage for some. Even with the best intentions of sticking with the debt-avalanche system, it is easy to revert to making minimum payments on all the debts, especially after you experience unforeseen expenses like auto or home repairs. That’s why most financial planners recommend that people first save up a six-month emergency fund before attempting any accelerated debt payoff plan.
- The debt avalanche is a systematic way of erasing debt relatively fast and cheaply for those who can stick with it.
- With a debt avalanche, you make the minimum payment on each source of debt, then use any remaining available funds to pay extra on toward the debts with the highest interest rates.
Not for Everyone, But It Works
The debt avalanche method of paying down debt is not for everyone. For example, it takes a great deal of discipline to see it through, enough money for daily living expenses, and extra money in the bank for emergencies. For those who can stay the course, however, a debt avalanche can be a good way to get out of debt relatively cheaply and expeditiously.
Similar to but Different From a Debt Snowball
The debt avalanche is different from the debt snowball, another accelerated debt payoff plan. In a debt snowball, the debtor uses money beyond the minimum payments to pay off debts from the smallest balance to the largest. Although this method costs more—in terms of total interest charges—the debt snowball method offers motivation by eliminating some small debts.