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.
INVESTOPEDIA EXPLAINS ‘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.