What Is the Debt Avalanche?
Have you ever wondered how on earth you ended up with so many credit cards? Probably, it was the intro deals that reeled you in. Who could pass on 0% APR for 18 months?
And then there are the offers for cash back, cash rewards, travel rewards. You might as well snag a couple more credit cards and pick up the freebies offered. After all, you’re going to spend the money anyway and it’s nice knowing that some of it will end up back in your pocket.
Only, that was then, and this is now. The 18 months of interest free spending has ended, and your APR has skyrocketed to 26%! Those cash rewards might have felt like free money at the time, but now you’re about to give it all back (and then some) in the form of interest.
You’re not alone here. Americans, on average, carry 3.4 credit cards and most of them owe a lot – about $5,700 per household – for those cards.
The total debt for revolving credit in the U.S. was $1.04 trillion, an all-time high, according the Federal Reserve. Credit card balances, which make up most of that debt, reached $870 billion in April of 2019, which matches the peak of the ’08 recession.
What makes those numbers difficult to swallow is that consumers paid more than $113 billion in interest alone in 2018! That means the 200 million card holders paid an average of $5,560 of interest to use their credit cards last year.
That is a jump of 48% over the last five years, and projections are they’ll pay another $122 trillion in interest in 2019.
Clearly, we could use some debt advice on how to pay all that back. That’s where debt avalanche comes in.
Debt Avalanche: Saving Time and Money
Debt avalanche sounds like a catastrophic financial crisis to be avoided, somewhere between foreclosure and bankruptcy.
Truth is, debt avalanche is a mathematically sound debt repayment strategy.
You start by paying off whatever credit card has the highest interest rate. Next, you pay off the card with the second highest rate, and then your third and then … well you get the picture: lather, rinse, repeat.
It can seem daunting to tackle that $10,000 credit card bill (with a 26% APR) when you’d rather take care of the $600 bill (with a 16.9% APR) first, but the numbers say you’ll spend less in the long run if you settle those high interest balances.
Credit card interest compounds, which means the longer you let it sit, the more out of control it will grow.
Let’s say you have a credit card balance of $10,000 with an APR of 26%. If you’re making minimum payments of $250 a month, it’ll take you about seven-and-a-half-years to pay back. And when all is said and done, you’ll have paid $13,500 in interest alone!
This is a simplified example, that assumes the interest rate remains the same over those seven-plus years, and you don’t add any more charges to your card while paying it off.
The point is, if you want to pay off your credit cards while spending as little as possible on interest, follow the debt avalanche method.
How to Use the Debt Avalanche Method
First, make a list of all your credit card balances ranging from highest interest rate at the top to lowest interest rate at the bottom. Next, list the minimum payments required for each card.
|Credit Card||Balance||Interest Rate||Minimum Payment|
Now step back and take a look at your budget that must include at least $310 for a minimum payment on the four cards. Decide how much extra beyond that $310 that you can allocate every month to paying off credit card debt.
Let’s say you have an extra $300 a month. You’ll make the monthly minimum payments on each card, and then pay another $300 on Card A. So, you’ll be spending $400 a month on Card A until it’s paid off.
Once that’s settled, you move on to Card B. You’ll pay the monthly minimum ($150), plus the $300 you’ve set aside for credit card debt, plus Card A’s former monthly minimum ($100). That comes out to $550 a month on Card B until it’s paid off.
You repeat this step with cards C and D until you are credit card debt free. That’s the debt avalanche.
Debt Avalanche vs. Debt Snowball
Where the debt avalanche takes a mathematical approach, the debt snowball method works to keep you motivated.
With the debt snowball method, you start by paying off your lowest balance before moving on to your second lowest balance. You’ll pay off your highest balance, regardless of interest, at the end.
The idea here is that small wins will keep us motivated and on track to get rid of debt. There’s some merit in this idea.
According to a Harvard study, humans may be more propelled by progress (or the perception of progress) than hard facts and statistics.
The study concluded that “it is not the size of the repayment or how little is left on a card after a payment that has the biggest impact on people’s perception of progress; rather it’s what portion of the balance they succeed in paying off. Thus, focusing on paying down the account with the smallest balance tends to have the most powerful effect on people’s sense of progress.”
This means that someone paying off a $1,000 credit card balance may feel a greater sense of accomplishment than someone who just paid $3,000 of their $4,000 credit card balance. The study argues that it’s this sense of accomplishment that’ll keep them on track to rid themselves of debt.
This might be true for some, but what if you do find comfort in numbers? What if the fact that one method saves you more money is all the knowledge you need to keep going?
Let’s take a look at how debt avalanche stacks up against debt snowball by the numbers. We’ll use the same credit card examples from before.
|Debt Avalanche||Debt Snowball||Minimum Payment|
|Repayment Period||19 Months||19 Months||53 Months|
If you started using the debt avalanche method in May of 2019, making your minimum payments, plus the additional payment of $300, you’d be credit card debt free by December of 2020. You’ll have paid $1,816 in total interest.
If you use the snowball method you’ll be out of debt in the same amount of time, but you’ll have paid a total of $2,125 in interest. In this example, the debt avalanche method saves you $309.
Now, you could take those savings from the avalanche method and make another payment to wipe your slate clean a month earlier, saving you time and money.
When to Use Debt Avalanche
The debt avalanche system works best when you have to tackle multiple high-interest credit cards. The quicker you eliminate the ones at the top, the more money you’ll save, plain and simple.
You don’t have to limit the debt avalanche to paying off your credit cards. It’ll work with most debts except for a mortgage.
Here are a few other examples of when to use the debt avalanche method:
- Student loans — Interest rates are usually on the low end, between 4%-7%, so they’ll likely take a backseat to credit cards and car payments.
- Car loans — The average interest rate is between 4%-8%, but if your credit’s bad it could be as high as 20%. A high interest car loan is a ripe contestant for debt avalanche.
- Personal loans — Another loan with varying interest rates, another good candidate for debt avalanche.
- Medical bills — You can often work these out with the hospital. Some will charge interest while others won’t. Even if they don’t charge interest, slipping it onto the bottom of your list is a good way to stay on track with your debts.
One thing to keep in mind is how your debt to credit ratio affects your credit score. While you’re slaving away at Credit Card A you may see a dip in your credit score if Cards B-D are maxed out. That’s because credit card bureaus like FICO take into account how much you spend versus how much you have available. This is called your credit utilization rate and ideally, you’ll want to have it below 30% on each card.
So, if you have a limit of $1,000, you’ll want to keep the balance below $300. This will be hard or impossible to do while paying off your credit card debt, but it’s something you may want to remember before maxing out another credit card.
A good credit utilization ratio is key in maintaining a strong financial portfolio. Credit cards, even multiple credit cards, can actually help more than hurt you. The crux is awareness. Always know how much you’re spending against how much you have available to pay off the debt. Get your credit cards to work for you, instead of the other way around.
Bents Dulcio writes with a humble, field-level view on personal finance. He learned how to cut financial corners while acquiring a B.S. degree in Political Science at Florida State University. Bents has experience with student loans, affordable housing, budgeting to include an auto loan and other personal finance matters that greet all Millennials when they graduate. He has a prodigious appetite for reading, which he helps feed with writing from Scottish philosopher Adam Smith, the “Father of Capitalism.” Bents writing also has been published by JPMorgan Chase, TheSimpleDollar and Interest.com.
- Fleming, John. (February 4, 2016) Americans' Big Debt Burden Growing, Not Evenly Distributed. Retrieved from: https://news.gallup.com/businessjournal/188984/americans-big-debt-burden-growing-not-evenly-distributed.aspx
- Bourassa, Betsy. (February 12, 2019) Total Household Debt Rises as 2018 Marks the Ninth Year of Annual Growth in New Auto Loans. Retrieved from: https://www.newyorkfed.org/newsevents/news/research/2019/20190212
- Trudel, Remi. (December 27, 2016) Research: The Best Strategy for Paying Off Credit Card Debt. Retrieved from: https://hbr.org/2016/12/research-the-best-strategy-for-paying-off-credit-card-debt