A new week, a new entry in the Book of the Debt. Perhaps, such a morbid reference to the ancient Egyptian Book of the Dead would be out of place with any other topic. But let’s be clear – your debt has the means to render your finances dead in the water. So heed caution, proceed with utmost vigilance – it’s time to eliminate your debts!
Is it perhaps because of how a borrower gets crushed under the unbearable burden of payments plus interest? Just like an avalanche? Well, not quite. Actually, the avalanche method is something entirely opposite. When using the avalanche method in repaying your loans you always start with repaying the highest interest loan. And then move on to the next highest interest loan. And so on and on. So it is not the financial burden that takes control of you – it’s you who takes control.
Another method of paying back debt is by starting with the smallest loan in terms of the loan amount and gradually move up the ladder until the largest loan is paid off. If you’re interested in learning more about it, we have an article on the snowball method of repaying debt.
How do I get my avalanche going?
When using the avalanche method in repaying your loans, you must first identify which loan has the highest annual percentage rate (APR) and sort the rest of your loans from there. Here’s an example:
- student loan – €10,000 with an APR of 2%
- credit card balance – €5,000 with an APR of 19.5%
- personal loan – €8,000 with an APR of 11%
- mortgage – €120,000 with an APR of 1.4%
Automatically, one might assume that the correct strategy is to first tackle the loan with the highest remaining balance. But, with the avalanche method, that is not the case at all. The avalanche method means:
- identifying which loan to cost ratio over the loans lifetime is the highest;
- restructuring your monthly budget in a way that will help you repay this loan sooner.
Knowing this, we can determine that to start your avalanche, you must first repay the credit card balance. This is the simplest example, since it’s very clear that over the normal 60-month payment schedule the credit card loan of €5000 will cost you anywhere from €7500 to €10,000+, depending on how your minimum monthly payment is calculated.
From there, your personal loan is your next most expensive loan, leaving student loan and mortgage as options 3 and 4, respectively.
You might argue that you will pay much more in total interest over the life of your mortgage. Yet it is simultaneously the highest amount, which will take the most time to repay either way you look at it. That’s why you leave it as the last, while still paying the minimum monthly payment every month.
There must be more to this… right?
Of course, simply identifying the most costly loan will amount to no progress at all. This is where you must use your budgeting skills to try and find excess funds in your monthly budget. We already looked at ways to cut your monthly expenses, but it can be anything – even searching for extra means of income.
Once you’ve done what’s necessary to acquire these long term excess funds, you then put them towards your credit card payments, while still paying minimum monthly payments towards all the rest of your loans. Paying just the minimum monthly payments can drag the process on for ages, while being unnecessarily expensive. Now, you can use those extra acquired funds towards your highest interest loan each month as well, repaying it much quicker and thus – cheaper.
Any type of loan will have its scheduled payments go both towards the interest and remaining balance, initially the portion towards interest being much higher. However, if you make additional payments each month, these payments go towards only the remaining balance.
Can I put my excess funds aside and make larger payments yearly instead?
With high-interest loans it is beneficial to make small additional monthly payments instead of putting your extra funds aside and making larger payments once a year. That’s due to the fact that the interest rate is charged towards the amount still owed. Therefore, you will pay more interest through the year than you would if making monthly payments.
It’s not as much an issue with lower interest loans, as over a shorter period of time the interest will not amount to much more than you would have if making yearly payments.
Once you get ahold of this method
The process will become easier each month, as you’ll notice the remaining balance of the loan shrinking rapidly. It will become especially easy, once you pay off your initial loan and can move on to the next loan with the highest interest.
Now, it’s important to grasp the fact that after repaying the first loan, you’ll have both the excess funds you used for additional payments and the amount of minimum scheduled payment to your use. You must now put all this additional resource towards the payments of the next loan. Only this way the avalanche method can be effective.
Your avalanche will grow in power as it moves down your list and leaves repaid loans in its wake.
This must be the best way to fix your finances and credit score, mustn’t it?
Slow down there. Using this method might not be suited for every occasion. There are situations where it’s in the best interest of the borrower to first repay the loan with the highest remaining balance, instead of the highest interest. It is up to you and/or your financial advisor to determine which way of tackling your loans is the best for your situation and your needs.
So, even if the avalanche method can be really effective if you use it correctly, there are other methods, too. Next time we’ll explore another one. With a similarly frosty name. See you then.