(This is the first part of a two-part series on debt repayment strategies. You can read Part Two here.)
Debt is an insidious force eating away at your financial freedom. Give it enough rope and it will hang you as it does thousands of Americans. Did you know that last year the average American household had over $15,000 in credit card debt? (Source). Today we’re going to talk about a powerful approach to blowing that debt up in part one of a two-part series.
Debt is an insidious force eating away at your financial freedom. Give it enough rope and it will hang you as it does thousands of Americans. Did you know that last year the average American household had over $15,000 in credit card debt? (Source). Today we’re going to talk about a powerful approach to blowing that debt up in part one of a two-part series.
The Avalanche Method
The portion of your debt that kills your financial freedom
is the interest rate. This is the fee an organization charges you to lend you
money. If compound interest on your retirement accounts is the Luke Skywalker
of good forces in the universe interest payments are the Darth Vader and
Emperor Palapatine combined evil rotting your bank accounts away.
So how do you get rid of your debt? Using the avalanche
method! Here’s how it works.
What money do you owe, and how much is it costing you?
Just like we learned in the 10Step Plan to Your Financial Freedom you need to know what you owe and to whom
you owe it before you can start repaying it. Contact all of the issuers of your
debt that you’re aware of. Don’t forget, you get a free copy of your credit
report each year so if you haven’t gotten yours yet you can get them here
from the official Government source (not one of those scammy sites trying to
charge you more money to get access
to your information).
Got your debts and interest rates figured out? Great, time
for the next step.
Write your debts down from highest interest payments to lowest
Once you know who you owe and how much you’re paying them to
owe them that money it’s time to figure out whom to pay off first. By listing
your debt from highest interest payment to lowest you’ll know which debt is the
most expensive to carry. For example, if you owe $1,000 on your credit cards at
30% interest and $5,000 in student loans at 3% interest, it costs you ten times
as much each month to owe money on that credit card as it does your student
loans. You want to get that credit card paid off ASAP.
Release the avalanche!
Now that you know which is the most expensive it’s time to
start paying that debt off. Each month after you’ve paid off your expenses,
made your minimum credit payments, and ensured your emergency cushion is at
least $1,000 (step2, remember?) you’ll take all the extra income left over and put it towards
that debt at the top of your list. When you pay more than your minimum payment each month your money goes towards
paying off the principal on your debt (the part you borrowed) instead of
towards the interest payment (the fee the lender is charging you).
Because the fee you pay to borrow is a percentage of the
amount you took as a loan paying off the principal lowers the rate that you’re
paying to borrow that money. It also means that you’re shortening the length of
time it takes you to pay that money back, saving you real dollars in the
long-term. So why do we call this method the avalanche? Because like a speeding
rush of snow hurtling down a mountain your debt payments are going to rush from
paying off one source of debt to the next growing larger and larger.
After you pay off your first debt your extra income will go
towards paying off your second debt, the one that carries the (now) highest
interest rate of the rest of your debts. Plus, because you paid off a debt you
no longer have the minimum payment from that loan each month meaning you have more money to put towards paying off
that next loan! Your avalanche builds up steam as you careen from one debt to
the next, building up cash momentum each time you pay a loan off. By the time
you get to the lowest interest rate loan you had to pay off your total cash
flow going towards that debt will be the largest of all and you’ll have it paid
off quickly.
Closing thoughts…
The avalanche method is the most cost-effective means of
paying off your debt. It will increase your cash flow the fastest, save you the
most money, and get you out of the world of paying someone to owe them money.
The best time to start the avalanche method? Right now. Seriously. The post is
over; go find out what you owe and to whom if you don’t know already and
unleash your avalanche.
Here's a dumb question; what about a mortgage? Try to pay that down avalanche style, too? That seems super daunting, but it IS our biggest debt.
ReplyDeleteDepends. On the 10 Steps I call that out; if it's over 5% interest, absolutely. That's a guaranteed rate of return close or higher than what an index fund will get you (estimated rate of return is 7%, but it's not guaranteed).
ReplyDeleteIf it's lower than 5% it's a matter of personal preference. Having a house paid off is a pretty big deal and increases your cash flow significantly. But if you're paying 3% on your house and your retirement accounts would earn 7% in a year, you get 4% more annually by investing in those over paying the house down payment.
Really the mortgage (if it's under 5%) comes down to personal preference. I prefer paying down debt, but then again I don't carry a mortgage presently. You certainly can't go wrong paying off additional debt, and don't get trapped in believing that just because a mortgage says "30 years" on it that you HAVE to take 30 years to pay it back. Putting extra money towards it will literally save you tens of thousands of dollars long-term.
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ReplyDeleteThank you for sharing such valuable and helpful information, tips and knowledge. This gives me more insights on this. I would love to see more updates from you.
ReplyDeleteTax Advisor