DEFINITION of 'Debt Avalanche'

A method of repaying debts in which a debtor allots enough money to make the minimum payment on each debt, then devotes any remaining  debt-repayment funds to repaying the debt with the highest interest rate. Using the debt avalanche method, once the debt with the highest interest rate is completely paid off, the extra repayment funds go toward the next highest interest-bearing debt. This process continues until all the debts are paid off.

BREAKING DOWN 'Debt Avalanche'

Here's how repayment by debt avalanche works:  Let's say you allot $500 every month to retire your three sources of debt: $1,000 worth of credit card debt (annual interest rate: 20%), $1,250 of car payments (6% interest rate) and a $5,000 line of credit (8% interest). For simplicity’s sake, assume each has a minimum monthly payment of $50.

You'd need to allot $150 toward paying each debt's minimum monthly payment ($50 x 3). The remaining $350 would be added to the money devoted to your highest-interest debt — in this case, you'd pay $400 toward settling the credit card debt. Once the credit card debt has been completely paid off, the extra payment would go toward retiring the second-highest interest bearing debt (the line of credit). Finally, all $500 would go to the debt with the lowest rate of interest (the car loan).

The major advantage of using the debt avalanche method is that it minimizes the amount of interest you pay, as long as you stick to the plan. It also minimizes the total amount of time it takes to get out of debt since interest doesn’t accumulate as quickly.

An alternate technique of debt repayment is the debt snowball. Instead of paying off debts from highest interest to lowest, this method uses the money beyond the minimum payments to pay off debts from smallest to largest. Although it costs more in interest, the debt snowball method can be better for individuals who find that the early victories of paying off a number of small debts – making the total number of debts on their list less daunting –motivates them to stick with the plan and see it through.

 

 

 

RELATED TERMS
  1. Net Debt

    Net debt is a metric that shows a company's overall debt situation ...
  2. Funded Debt

    A funded debt is a company's debt that will mature in more than ...
  3. Junior Debt

    Junior debt is debt that has a lower priority for repayment than ...
  4. Effective Debt

    Effective debt refers to the sum of all of a company's outstanding ...
  5. Debt Ratio

    The debt ratio is a financial ratio that measures the extent ...
  6. Debt Fatigue

    Debt fatigue is when a debtor becomes overwhelmed by the amount ...
Related Articles
  1. Personal Finance

    Best 5 Money-Saving Tips to Get out of Debt

    Understand the different types of debt and the reasons why people get into debt. Learn about five tips to follow to get out of debt.
  2. Personal Finance

    Why Debt Isn’t Always a Bad Thing

    When managed properly, debt can be used to achieve a higher overall rate of return.
  3. Personal Finance

    How to Invest When You're Deep in Debt

    Find out how debt often prevents people from investing. If you are borrowing, you can still learn to balance your debt with saving and investing.
  4. Financial Advisor

    The 4 Best Debt Reduction Services

    It can be tricky to find the best debt reduction services for your financial situation. These top 4 debt consolidation firms help make the process easier.
  5. Investing

    To invest or to reduce debt – that's the question

    How to make the best use of excess cash to pay down debt or invest money to improve your financial situation.
  6. Personal Finance

    Debt Settlement: Cheapest Way to Get Out of Debt?

    Debt settlement is not for everyone, but for those seriously in debt it may prove an effective means of solving the problem.
  7. Personal Finance

    What Millennials Should Know About Good and Bad Debt

    Can you tell the difference between good and bad debt?
  8. Personal Finance

    Sizing Up Debt

    Ever wonder if the different types of debt are good or bad? Read on and we'll tell you.
  9. Insights

    How Debt Limits A Country's Options

    While debt is fundamentally necessary to the operation of a national government, it can also be limiting and dangerous.
Trading Center