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3 BIG mistakes people make when they pay off debt with the avalanche method!

Tags: debt

There are two common and popular ways to pay off debts — The “snowball method” and the “avalanche method”. This article is going to focus on how you can pay off Debt with the avalanche method!

pay off debt with the Avalanche Method
Debt can be tackled like an avalanche!

How it works

Analogies are sometimes weird ways to describe financial strategies, but you’ll find the business world is full of them. One way to get rid of debt and pay it off quickly is through something called the “avalanche method”. It is named so because avalanches start at the highest peak, and roll down to the base of a mountain.

Ok, but how do you actually pay off debt with the avalanche method? In a similar way, while you may be looking at a significant amount of accumulated debt, don’t lose hope! By starting at the top of the debt mountain and being consistent, you can pay off a significant amount of debt off very quickly. Here’s how to do it:

  1. List out all of your debts and loans, including minimum payments and interest rates
  2. Sort the list from lowest interest to highest interest
  3. Take the highest interest debt and focus on that debt first! This is the top of your avalanche!
  4. Pay as much as you realistically can to get rid of this debt first, and only make minimum payments on all your other debts.
  5. Once that debt is gone, take the money that you would have been paying towards your highest interest debt, combine it with your minimum payment for the second highest debt on the list. This is your avalanche getting bigger and rolling down to the base of the mountain.
  6. Keep repeating steps 2-5 until you are finally at the base and no more debt is left.
  7. Congratulate yourself for paying off all your debt! You’re done! Try to make sure you never take on unreasonable debt again and keep finances under control.

An example scenario

Lets say that you have four debts as shown below:

BalanceMinimum paymentInterest rate
Student loan$500$403.25%
Auto loan$300$454.75%
Personal loan$600$308%
Credit card debt$3,400$5018.5%
The credit card debt should be tackled first since it has the highest amount of interest!

Note that these debts are already listed in order of increasing interest rate (step 2 above)

Next, you determine that you can pay $400 towards your debt every month without feeling like you’re burdening yourself or stretching yourself too thin.

This means that you can pay $285 towards your highest interest debt and the remaining $40 + $45 + $30 = $115 towards your minimum payments for all the other debts every month.

Keep making minimum payments ($115) towards your student loan, auto loan, personal loan, but pay everything else ($285 left over from $400) towards your credit card debt! By using our credit card payoff calculator, you can see that you will have paid off that debt completely within 13 months. Next, you will do all the same steps to pay down your second highest interest rate debt in the list — the personal loan!

With the credit card debt completely gone, you can now dedicate $40 + $45 = $85 towards your minimum payments for the student and auto loan, and $315 towards the personal loan. You should have that whole personal loan paid off in 2 months by doing this. Then repeat the process with $40 minimum payment going towards the student loan, and everything else being put towards the auto loan.

Is the avalanche method right for me?

I don’t personally believe the avalanche method is for everyone, especially those who have a hard time managing their money and ended up with unwieldy debt in the first place. It takes strong will to use the avalanche method. It takes a long time to see full balances being paid off, even though mathematically it MAY make sense to pay higher interest balances first. Here are reasons why I would not recommend the avalanche method for those who’d like to start tackling their personal debts.

Motivation

The snowball method allows you to see smaller gains and progress much quicker than the avalanche method. By focusing on the smallest balances in the snowball method, you can quickly wipe off debt line items. With the avalanche method, you may not be able to remove any debt for a long time. Don’t make the mistake of undervaluing the appreciation and relief you feel when a debt, even a small one, is completely paid off.

Highest interest percentage DOES NOT mean highest interest paid

Many people make the mistake of thinking that the highest interest percentage is the debt to focus on. Consider this counterexample:

  • Debt #1: $1,000 balance with 3.5% APR
  • Debt #2: $200 balance with 8% APR

Which debt do you pay first with the avalanche method? If you said Debt #2, you’d be WRONG. You want to pay the debt with the highest interest. This does not necessarily mean the highest interest rate!

If left unpaid for a month, Debt #1 would cost you an extra ($1000 * 0.035) / 12 months = $2.92 extra in interest. This means your new balance, with interest, would be $1002.92

If left unpaid for a month, Debt #2 would cost you an extra ($200 * 0.08) / 12 months = $1.33 extra in interest. This means your new balance, with interest, would be $201.33

Even though the interest rate on Debt #2 is higher, you’re accruing more interest every month on Debt #1 because the starting balance was a larger number! This means you should be paying Debt #1 down first to save more money in the long run.

But for some people, seeing this caveat in the avalanche method may be too complicated, involved, or mathematically advanced. The snowball method doesn’t have any of these nontrivial calculations to make sense of which debt to pay first.

Do the research: compare the two methods

If you haven’t already, plug in your numbers into an online calculator to help you see how much money you’re really going to be saving with the avalanche method. Then take a look at the amount of time to pay off all your debts with either method. If one method is better for you, stick to that one. Don’t make the mistake of blindly picking one method over the other — do your research.

My general recommendation for anyone trying to get out of debt is to consistently stick to the snowball method for these reasons.

Let us know in the comments below: Have you used the snowball method or the avalanche method to pay down debts? Which one did you prefer to meet your goals?



This post first appeared on Gen Y Finance, please read the originial post: here

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3 BIG mistakes people make when they pay off debt with the avalanche method!

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