What is a debt avalanche? It sounds like a pile of debt roaring down a mountain to bury you, but it’s not.
A debt avalanche is a method of paying off debt. With this strategy, you aim to pay off the debt with the highest interest rate first, thereby saving yourself the most money.
Here’s how it works. You make a list of your debts and their corresponding interest rates. If you don’t even know what the interest rates on your debts are, you’re not alone. Many consumers have never thought to look at their interest rates, or they purposely don’t look because they don’t want to think about it.
But if you’re reading this, you’re probably starting to get serious about tackling your debt for real, so you’re likely more ready to learn what the interest rates on your individual debts are.
Interest rates on home mortgages are probably some of the lowest, but we aren’t going to get into that here, since paying off your house isn’t something most homeowners can do quickly. You may refinance at some point to save money if interest rates go down, but you can’t just tighten your belt to pay off your mortgage sooner.
However, if you have a second or third mortgage or a home equity line of credit that you’re paying on, those rates are higher and you should list that on your debt avalanche plan.
Varying Interest Rates
You’re more likely to know the interest rate on a student loan or a car loan because of all the paperwork you had to do to get them.
But not everyone reads the credit card terms and conditions before they start swiping them all over the mall.
Managing your credit card online can sometimes make it even easier to amass more debt. When you get a credit card bill in the mail and you open it up, you have all the information on paper right in front of you. You can choose to throw it away, unopened. But if you look, you can see what you bought, how much you owe and what payments you have made.
When you look at your account online, you have to navigate around to find this information.
Calculating the Payback
Let’s say you owe $5,000 and you are making the minimum payment of $50 per month. With an interest rate of 10 percent, it would take you 17 years to pay off this debt. When you load these specs into a payment calculator and change the interest to 15 percent, the time it takes to pay off your debt changes to “infinite” because at $50 per month, you couldn’t even keep up with just paying the interest.
There are all different ways to become mired in debt, but credit cards’ high-interest rates and ease of use make this consumer convenience a particularly dangerous trap. Unless you owe money to a loan shark or pawn shop, a credit card will likely carry the highest interest rate of all your debts.
If you have several credit cards, check out the interest rates on each. You may be surprised, especially if they have changed. A credit card company can’t just change your interest rate without warning. However, changing rates are often built into the initial agreement, and consumers sometimes don’t read this carefully before agreeing to the terms and using the card.
Alternatives to Debt Avalanche Method
Whereas it is true that paying off the debts with the highest interest rates will save you the most money in the long run, sometimes if your debt is particularly high, it can be difficult to stay motivated to pay it down. When you figure out how much you can realistically pay toward your debt each month and how long it will take to pay off in full, you may become discouraged and feel like giving up.
When considering strategies for paying off debt you might find it helpful to use a debt avalanche calculator. That tool can give you the information you need to compare this method to others.
Another method of paying debts — the debt snowball — has you paying the smallest debts off first so you have fewer bills each month. This won’t save you money, but it can give you a feeling of satisfaction, much like crossing items off your to-do list.
The debt snowball method gives you a chance to pay off small debts so you can gain momentum over time. You feel a sense of accomplishment with each debt that you pay off so you are motivated to continue the process. As you pay off your small debts you have more money freed up that can be added to what you pay each month on larger debts. So as time goes by and you pay off more and more of your debts the effect snowballs.
To determine if this method is the best choice for you, use a snowball calculator and compare those results to the results the debt avalanche calculator provided.
While the debt snowball is a legitimate way to pay down debt, what might make more sense for you is consolidating your debts. That way, you would just make one payment on one loan and you would know when it was paid off. Further, if you have several credit cards and tend to lose track of when payments are due on each one and you keep paying late fees, a consolidation loan could fix that problem.
However, if you set up automatic payments from your bank account, that could also fix the problem of incurring late fees. But if you don’t always have enough money in your account and you end up paying overdraft fees, that will be just as bad.
A consolidation loan can help you a lot with high credit card interest rates, but not always with other types of loans like car loans. Car loans are secured, which means if you don’t pay, the lender can repossess your car. Other types of loans are unsecured, and these come with higher interest rates.
Thus, if you fold your car loan into a consolidation loan, you may end up paying more in interest. However, if your credit score was not good when you originally took out the loan and it’s better now, you may get a comparable or even a better interest rate. Car loans from private lenders come with some of the highest interest rates of all.
Consolidation Loan Pitfalls
Beware of consolidating your debts on your own without the help of a credit counselor. It’s easy enough to find zero-interest credit cards online that encourage you to transfer your balances from other cards to theirs. But this can sometimes end up being a trap.
Chase is offering a 0 APR Visa card, but at the end of 15 months, the interest rate is 16.49 -25.24 percent. The average interest rate on credit cards now is 16.32 percent. So if your rate is on the low end, it won’t be worse when the new rate kicks in, but if you make a late payment and it spikes up to the high end, you could end up with more problems than you have now.
Transferring balances also frequently comes with a fee. The offer above allows you to transfer balances for the first 60 days with no fee; it’s 5 percent thereafter. A 5 percent transfer fee can be hefty and eat into your savings.
You might think you could save money by bailing on the bank when your zero-percent interest rate is up and transferring your balance to a new zero-percent card. It’s not impossible to do this, but it hurts your credit score, so it’s not a good idea.
All this being said, 15 months with no interest can save you a lot of money. But you have to be sure you have the discipline — and the funds — to pay down a lot of your debt in this time. New purchases you make will likely not qualify for the 0 percent rate either. While you shouldn’t make a lot of new purchases while you’re trying to pay down debt, you still need groceries and other necessities. But don’t use your new credit card for these, use a debit card.
Using the debt avalanche method can help you pay off your debts quickly and save more money. But know that you must be focused and dedicated in order to achieve your goal of becoming debt-free.