There’s so much advice out there that promises to help you find your way out of debt – Stop investing. Start saving. Earn extra cash. Cut down expenses. Start with the smallest debt. No, start with the highest debt. As confusing as this gets, getting out of debt isn’t as hard as you think.
If you’re reeling under a mountain of debt, then the term ‘debt avalanche’ might seem like an apt description for your woes. But in fact, this term could actually solve your problems and help you pay off debt faster. How, you ask? Read on.
What is ‘Debt Avalanche’?
Debt Avalanche is an often-recommended and very popular debt repayment strategy in which high-interest debt is paid off first while minimal payments are made towards other debts. Instead of starting small and gradually working your way up, this method starts right at the top. The idea is to target and clear off high-interest debt that is more likely to cost you higher in interest payments in the longer run and is best for those who want to take a more mathematical approach to paying off their debt.
How can it help you repay your debts faster?
Let’s take a look at an example to understand how this method works.
Suppose you earn AED 10,000 per month and can set aside AED 7,500 to pay your debts after accounting for living costs and other expenses. Let’s assume you have the following three debts to start with:
- AED 230,000 worth of education loan at 4.5% interest annually
- AED 30,000 in credit card debt at 35% interest annually (APR)
- AED 120,000 worth of car loan at 3.5% interest annually
Applying the debt avalanche methodology, you’d opt for the minimum monthly payments on your education and car loans, while pooling all extra money towards paying off the loan with the highest interest, which in this case is your credit card debt. Assuming that you are required to pay a minimum of AED 2,000 on each debt, you can set aside an extra sum of AED 1,500 to use towards paying off your credit card debt. This way, you’ll find that you can close the credit card debt sooner. Once that’s done, you can put all the extra money towards the debt with the next highest interest rate, which would be your education loan. And post that, you would allocate all the extra funds towards your car loan.
[Related: How can you pay off your loans faster?]
Is this the best debt repayment strategy around?
The debt avalanche method minimizes the interest accumulated over time. As you pay off more of the principal balance, it helps you save more and pay off debt faster than possible through any other method. There’s another debt repayment method that’s also very popular: Debt Snowball, which focuses on paying off the smallest debts first. This strategy is good for motivation, as it often feels great to wipe out one of your debts entirely. However, you will end up paying more interest over time compared to what you would pay with the debt avalanche route.
Extra tips to make Debt Avalanche work for you
When paying off debts using this method, remember to commit to two things:
- Remember to follow a strict budget so you can free up more cash to put towards paying off your highest interest loan.
- Once the highest interest debt is paid off, use the money you had allocated towards that as extra cash to pay off your next loan.
Being consistent with this debt repayment strategy can not only help you weed out your debts faster, but will also prove cost-effective in the long run.
Give it a go and let us know how it worked out for you in the comments section below!