You must have read about the Debt Snowball Strategy. Here, I am presenting an alternate method to deal with your debts, i.e. the Avalanche strategy. An individual with multiple debts may eventually get frustrated dealing with the debts. However, we bring some strategic moves for your profit so that you can handle your finances more efficiently. Once you understand both the debt management methods, you debate on the right debt resolution strategy for you and implement it to your advantage.
What is the Debt Avalanche Strategy?
The Debt Avalanche strategy is the most preferred and suggested method by financial planners and debt counsellors. All that you have to do is:
- Rank your debt based on the interest rate, i.e. from the highest to the lowest.
- Set the debt with the highest interest rate aside.
- Pay the minimum instalments to all the other debts in the list.
- Dedicate the highest amount from the remaining sum on your budget towards the debt with the highest interest rate.
- Once you clear the debt with the highest rate, prioritise the debt with the next highest rate.
The Idea Behind the Avalanche Method
The Avalanche method preaches individuals to pay off the debt with a higher interest rate. This is to avoid the large sum you pay towards the interest component of the debt. There can be times when the amount that is deducted towards the interest component is much higher than that deducted towards reducing the principal from your equated monthly instalments (EMI). This can be avoided when you reserve more resources towards the debt with a higher interest rate.
Once you settle up the debt with the highest interest rate on your list, you will be left with a more significant sum at hand. You can utilise this remaining sum for clearing off the other debts sooner.
Illustration to Explain Avalanche Method
Consider that you have borrowed Rs.1,00,000 from your friend and he does not expect any interest payment on this money. Say, you have a credit card balance of Rs.50,000 at a monthly interest of 3% and a personal loan of Rs.2,00,000 at the interest rate of 10% p.a.
When you rank the debts you have based on the highest interest rate first, the following will be the order:
- Credit card debt – Rs.50,000 – 36% p.a.
- Personal loan – Rs.2,00,000 – 10% p.a.
- Loan from friend – Rs.1,00,00 – 0% p.a.
Based on the interest rates, the Avalanche strategy demands you to prioritise the credit card debt with the highest interest rate of 36% p.a. Therefore, you will be required to make a minimum payment of 5% of the outstanding balance, i.e. Rs.2,500 per month. The minimum amount you can make towards your loan is Rs.10,000 since the repayment period for the loan is two years. Also, consider that you have decided to repay Rs.5,000 per month to your friend.
If your total budget towards debt repayments is Rs.20,000 per month, start paying the minimum payable amount of Rs.10,000 and Rs.5,000 towards the personal loan and your friend. Since you will be left with Rs.5,000, pay this sum towards the credit card debt where the minimum payment is Rs.2,500. This will help you get over the credit card debt sooner and pay relatively less towards the interest element.
Once you pay off the credit card debt, you will have an additional Rs.5,000 at hand. You can, then, prioritise the personal loan with an interest rate of 10% p.a. and spend this additional sum at hand towards paying off your loan. Remember that you will still pay Rs.5,000 per month to your friend. By the time you pay off the personal loan, you would have paid off a substantial amount to your friend. Further, you can dedicate the entire Rs.20,000 monthly budget to pay off the money borrowed from your friend.
Both Avalanche and Snowball methods are logical and give you the confidence to deal with your loans. However, you must calculate and compare the time each of the methods takes to pay off debts in your specific case. Please choose the method that suits you the best and implement it to your finances. I hope it helps!
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