Recently a new way to repay loans, such as debt avalanche, was introduced to borrowers around the world. A supporter of the “debt avalanche” method and the author of “Dear Debt” Melanie Lockert claims to have repaid her student loan in five years using the method and even had some cash to spare. Let’s look at how the method works and what aspects to bear in mind in order not to get trapped under the debt avalanche.
The debt avalanche method is often paired with the “wealth snowball” method. Using the “snowball method” you rate debts by their balance and aim to repay more than you owe on your minimum monthly balance.
How the “Debt Avalanche” Works
This method is claimed to assist in repaying all types of existing debt, either a student loan, a personal loan or a quick loan issued online. Usually, people have multiple loans, each with a different balance and interest rate. Get your multiple loans in order, repay the minimum for each debt but cover the biggest debt first. Using this method you should always thrive to repay more than a minimum.
The interest rate implied by the debt is its priority. Judging by this criteria, you can repay the student loan first, focus on the car insurance payments next and finish off with the smallest debt.
How to Organize Payments by the “Debt Avalanche” System?
1. Order the debts according to their interest rate. Get the debts in order starting from the one with the highest interest rate and ending with the lowest interest rate. The credit card usually goes at the top of the list.
2. Pay the minimum amount on all the debts monthly. If possible pay more than a minimum.
3. Any extra money you have goes to the highest interest rate debt.
4. Repeat monthly.
How Does “Debt Avalanche” Come off Compared to the “Snowball” Method?
If compared with the “snowball” the “debt avalanche” method allows you to pay off the debt if not faster but losing less money, thus saving it. However, even with all its benefits, the “debt avalanche” method fails when it comes to people sticking to their repayment plan. A study by Kellogg School of Management showed that instead of focusing on saving money in the outcome, borrowers would rather pay off the smaller debt first. When they close debts faster it keeps them motivated.
A study conducted by the Boston School of Business also demonstrated that people tend to keep their attention better on one account at a time. This way they see the progress better and do a better job of repaying the debt.
Do Your Own Math
Let’s take an ordinary family with traditional spending patterns, two cars, a student loan to repay, and regular credit card payment to cover.
Consider a family is ready to put aside a $1,000 towards the debt each month. This way, theoretically using both methods the total debt will be repaid in five years and four months. Having used the “debt avalanche” method the family would pay $8,394 in interest. Had they used the debt snowball method, they would have repaid $9,378 in interest. This leaves them with a difference of $985 within five years. The sum is not that small and every household could use an extra $1,000. But if they break this sum into months, it’s only a $15.15 difference.
What Method Works Best for You?
Seeing the two methods at work, that’s what a borrower must do in order to choose a suitable one:
- Do the math. Calculate your debts and determine the lucrative difference in methods.
- Define the rational option. Focus on what matters most for you: either seeing as the small debts being paid off one by one faster or the profitable outcome of the method.
- Understand your money management organization. Define what system will help you better keep track of the existing debts.
Remember that choosing the repayment method is only half the race. Paying off the debt is a series of smart steps from careful budgeting to increasing your income in order to repay the debt faster.