FutureNOW 'Cascade' Debt Reduction
Borrowing money can help you accomplish great things, but you need to pay interest when you borrow. Ultimately, those interest charges increase the cost of whatever you buy, and monthly payments can limit your freedom (not to mention your ability to borrow for other purchases).
Here, we'll examine two different methods, Debt Avalanche & Debt Snaowball.
If you’re serious about eliminating debt and minimising interest costs, you may want to use the debt avalanche method of debt payoff.
What Is Debt Avalanche?
Debt avalanche is a strategy of paying off what you owe by prioritising loans and credit card balances with the highest interest rates. The goal is to minimise the amount of interest you pay, and this approach might help you pay off debt faster than other strategies like the Debt Snowball.
Here’s how to save the most on interest with the debt avalanche method:
Take inventory: Gather a list of everything you owe. List your debts in order of the interest rate on each loan or credit card, starting with the highest rate and working down to the lowest.
Pay your minimums: Keep making minimum payments on all of your loans or credit card balances. You’ll focus on one balance at a time, but you need to stay current on the others to avoid fees and damage to your credit score.
Pay extra on the highest rate: With any additional money you have available each month, pay extra on the loan with the highest interest rate. You’re reducing the amount you owe at that high rate.
Build momentum: Once you pay off a loan, cross it off the list and move on to the loan with the next highest interest rate. The previous loan’s minimum payment (which you no longer need to pay) becomes available for additional debt payments.
Debt Avalanche Example
Assume you owe money on the loans detailed below. Based on your monthly budget, you know that you have an extra $150 available each month for debt elimination. Which loan should you pay off first?
List each of your loans in order of the interest rate, with the highest rate at the top.
With the debt avalanche method, your additional $150 goes toward your credit card payment because that loan has the highest interest rate. As a result, you pay $630 to your credit card issuer (the $480 minimum payment plus your $150 extra) monthly.
After paying off your credit card, that minimum payment goes away, so you have even more cash flow available each month. The $630 you were paying to your credit card company can now go toward your personal loan. As a result, you pay $669.60 ($630 plus your required $39.60), which quickly eliminates the remaining loan balance.
Next, you fold what you were paying on the personal loan into your additional payments, so you pay an additional $669.60 per month on your student loan. The total amount you send to your loan servicer is $853.34 ($669.60 plus your required $183.74).
Continue the process until you are debt free.
Why It Works
Debt avalanche is an effective strategy because it focuses on interest rates. On most loans, a portion of each monthly payment goes toward interest charges, and the remainder reduces your loan balance. With high rates, you need to pay more to cover interest costs, and your payment might only make a small dent in your loan balance. By minimizing your overall interest rate, you waste less money on interest.
Is This the Best Strategy?
Debt avalanche is an excellent strategy for minimising costs and getting out of debt and is the fastest way to be debt free.
For some, a debt snowball strategy might be a better option. That’s particularly true if you’re likely to lose motivation during your debt elimination journey. The debt snowball method provides small victories early in the process, which can help you stay disciplined and keep hope alive.
How the Debt Snowball Method Works
With the debt snowball method, you pay off your smallest debt first and move on to the next-smallest debt, and then the next-smallest, and so on. During the process, you continue making the required minimum payments on all of your loans, with any extra money each month going toward your targeted debt.
Here are the steps you need to take.
Get organised: Make a list of all of your debts. Put with the smallest balance you owe at the top, with the next-smallest in the line below that, and then the third-smallest in the line below that, and so on. As you build your list, ignore the interest rates, monthly payment amounts, and other loan features. At the bottom of your list, put the largest debt.
Pay the minimums: If you don’t pay the minimum required on all of your loans and credit cards, you may have to pay fees and penalties, and it may damage your credit scores.
Pay extra on your smallest balance: Put any extra money available each month toward the credit card or loan at the top of your list. Your goal is to aggressively pay off that balance.
Build on your success: After paying off your smallest balance, cross it off the list and move on to the next-smallest balance. You no longer need to make minimum payments on the loan you just eliminated, so you should have even more money available every month for extra payments.
The Strategy in Action
Note: In addition to providing a series of relatively quick victories, the debt snowball allows you to pay off loans at an increasing speed over time.
Assume you have several loans outstanding. Your monthly budget shows that you have an additional $100 available each month for extra loan payments. Where should you put that money?
To answer that, first list each loan or credit card debt from the smallest loan balance to the largest.
With the debt snowball, your extra $100 per month goes to your personal loan first. As a result, you pay $139.60 (the required $39.60 plus the additional $100) to that lender each month.
Snowball effect: After you pay off each loan, that loan’s payment becomes available for additional debt payments.
After paying off your personal loan, you now have $139.60 extra for the next loan (because you don’t have to pay your personal loan lender anymore).
You send extra money each month to your student loan servicer. The payment will be the required $183.74 plus $139.60, for a total of $323.34.
After paying off your student loan, you have an additional $507.08 available each month for paying off your credit card.
The process continues to build momentum until you finally wipe out all of your debts.