What is a 'Debt Avalanche'

A debt avalanche is a type of accelerated debt payoff plan. Specifically, a debtor allocates enough money to make the minimum payment on each debt, then devotes any remaining debt-repayment funds to the debt with the highest interest rate. Using the debt avalanche method, once the debt with the highest interest rate is entirely paid off, the extra repayment funds go toward the next highest interest-bearing loan. This method continues until all the debts are paid off.

BREAKING DOWN 'Debt Avalanche'

The first step in employing a debt avalanche approach is to designate the total amount of monthly income available to pay debts. This amount is any funds not currently obligated for living expenses such as rent, grocery, day care, or transportation expenses. 

As an example, imagine you have $500 available every month after paying for living expenses to put towards debt payoff. Your current loans include:

  • $1,000 due on a credit card debt with an annual interest rate of 20%
  • $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’d need to allot $100 toward paying each debt'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 a total of $450 toward settling the credit card debt charging a 20% interest rate. The card debt will be entirely paid off by the fourth month, assuming no additional charges added to the card balance. Now, the extra funds 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 Debt Avalanche Reduces Interest But Takes Discipline

The advantage of the debt avalanche 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 constant payments, since 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.

The disadvantage of the debt avalanche is that it takes discipline and commitment to pull off. It is easy to revert to making minimum payments on all the debts, especially after unforeseen expenses like auto or home repairs. That’s why most financial planners recommend people first save up a six-month emergency fund before attempting any debt payoff accelerator plan.

Different From a Debt Snowball

The debt avalanche is different from the debt snowball, another accelerator 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 will it costs more, in the total amount of interest charges, the debt snowball method does motivate with the elimination of some small debts.

RELATED TERMS
  1. Net Debt

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

    Debt service is the cash that is required for a particular time ...
  3. Debt Fatigue

    Debt fatigue is when a debtor becomes overwhelmed by the amount ...
  4. Debt Consolidation

    Debt consolidation is the act of combining several loans or liabilities ...
  5. Effective Debt

    Effective debt refers to the sum of all of a company's outstanding ...
  6. Long-Term Debt to Capitalization ...

    The long-term debt to capitalization ratio, calculated by dividing ...
Related Articles
  1. Personal Finance

    The Best Ways to Eliminate Student Loans

    You went to college and got the degree. Now it’s a matter of paying off that debt. Here's how.
  2. Personal Finance

    Before Taking on Debt, Ask These Questions

    To understand the difference between good and bad debt, ask these questions before borrowing money.
  3. 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.
  4. Personal Finance

    Sizing Up Debt

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

    Debt Consolidation Made Easy

    Five steps to consolidate and pay off your debt.
  6. 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.
  7. Personal Finance

    Should I Invest My Savings or Pay off Debts?

    Is it better to pay off debt, or just pay the minimum and invest at the same time?
  8. Personal Finance

    How Much Credit Card Debt Do Americans Have?

    Household debt is on the rise in the U.S., with credit cards, car loans and student loan debt representing major threats to Americans’ financial health.
  9. Personal Finance

    Expert Tips for Cutting Credit Card Debt

    Managing your debt could mean the difference between spending $45,000 or saving $184,000.
Trading Center