Debt Avalanche Technique
5 August 08If you have multiple debts (which many people do), it can be tricky to determine which debt to pay off first.
I have created what I call the debt avalanche technique which helps you identify target for rapid pay off, your debt avalanche. Should any extra money come your way by either windfall or additional earned income, or by careful budgeting and reducing your expenditure, this money should all be applied against this debt.
|
Name of Debt |
Amount |
Minimum Mthly Repayment |
Timing |
Interest Rate |
|
|
ABC Bank (Car Loan) |
5,000 |
195 |
25.64 |
10.5 |
5 |
|
XYZ Bank |
3,000 |
90 |
33.33 |
22.0 |
2 |
|
Store card |
750 |
50 |
15.00 |
20.0 |
1 |
|
AAA Bank |
1,500 |
75 |
20.00 |
18.5 |
3 |
|
Home Mortgage Corp |
100,000 |
733 |
136.36 |
8.0 |
6 |
|
Lease Company Ltd |
2,900 |
100 |
29.00 |
18.0 |
4 |
Six Key Steps to Prioritise your Debt Avalanche Plan:
1. List out using the same format as the table above, whom you owe and what the debt was for (column 1).
2. List the amount or balance owed (column 2). This does NOT include future interest. This means what you would have to pay if the debt was paid out today.
3. List the minimum monthly payments for each debt (column 3)
4. Divide the amount owed by the minimum monthly payment, and place the answer in the timing index column (column 4). The higher this number, the less immediate impact it is having on your cash flow. Conversely, the lower the index number the greater it’s effect on your cash flow. Consequently the debt with the lowest index number is the debt you should target first for your avalanche repayment strategy.
5. List the interest rate for each debt (column 5).
NOTE:- If you have leased or hire purchased anything, just treat the lease or purchase agreement like any other loan.
6. Determine which debt you will pay off first - In most cases you will want to pay off the highest interest rate debt first, but not always.
In the above table you will notice I have put the 20% debt ahead of the 22% debt. I have done this for two reasons. Firstly because it has the lowest index number and is therefore having the greatest impact on Mrs X’s cash flow. And secondly because the interest rates are extremely close to each other and the Store Card Loan for the lounge is small, so it can be paid off quickly.
This creates excitement and builds momentum in your debt elimination mission. Generally you would only pay off the smaller interest rate debt first if the debt is small and can be paid off in just a few short months or if the interest rates are very close.
Now let’s assume that Mrs X has just paid off her store card debt and now has an extra $50 per month to apply to her visa card debt.
When this debt has gone, Mrs X will then have an extra $140 per month to pay off her master card debt. Just follow this process until each debt is paid off. It is thrilling to remove each debt from you list!
Once the amount of debt decreases and the payment you are able to repay off your next debt on your list continues to get larger, it is very exciting to see how fast you can begin to take a serious bite out of your total debt.
In Mrs X’s case she would continue this process until all her core bad debt is paid off – that is every thing except her home loan and possibly her motor vehicle lease if the vehicle was used for business purposes and was therefore at least partly tax deductible, before she would start to consider investing her excess cash flow into income producing assets that earned her more income than the 8% her home mortgage was costing her.
The Debt Avalanche Strategy is an essential process in taking control back of your finances and ultimately your life. It will give you more peace of mind than you can ever imagine and a real sense of pride and accomplishment.
Let me use another example just to make sure the importance of this avalanche effect is absolutely clear.
Consider this:-
1. A couple own a house with a $100,000/30 year mortgage at 10% interest with an $877 monthly principle and interest payment.
2. They also owe $3,600 on their credit card at 21% interest. They are paying $72 a month and if they don’t charge any more to their card, they will pay off the card in 10 years.
3. They owe $5,000 for a furniture loan. It is a 5 year loan at 13% with a monthly payment of $111.
4. They also owe $16,000 on a car. It is a 5 year loan at 9% and has a $332 per month repayment.
Let’s put this information into an Debt Elimination Avalanche Table so we can better assess their situation
|
Name of Debt |
Amount |
Minimum Mthly Repayment |
Interest Rate |
|
|
ABC Bank (Car Loan) |
16,000 |
332 |
9.0 |
3 |
|
Store card |
5,000 |
111 |
13.0 |
2 |
|
AAA Bank |
3,600 |
72 |
21 |
1 |
|
Home Mortgage Corp |
100,000 |
877 |
10.0 |
4 |
Let us further assume that by applying all 10 steps to eliminate debt listed above, they are able to find an extra $60.70 a week (that’s $263.00 a month) and direct this to the debt they have targeted for Debt Elimination Avalanche. In this case that debt would be their AAA Bank Master Card. With the help of the extra $60.70 per week or $263.00 per month, they are now able to lift their monthly repayment on the debt to $335 per month. ($335 per month is calculated by adding the extra $263.00 per month to their existing minimum repayment of $72.00).
They have now begun their Debt Elimination Avalanche!
By taking this action our couple would pay off their AAA Bank Master Card in just ONE year instead of TEN years.
In year two, they now take the $335 (i.e. the original $72 and the additional $263) which they were using to pay off their Master Card which now has a zero balance, Yeh!, and add it to the $111 furniture loan payment. Their furniture loan payment now becomes $446 a month and would have their furniture loan paid off in just ONE more year instead of FOUR YEARS.
In year three, if they now take their original Master Card repayment and their old furniture loan payment of $446 and add them to your $332 car payment, thereby paying $778.00 per month off their car loan, they would have their car loan also paid off in just ONE more year instead of THREE more years.
And yes, you guessed it, in year four they could then take all their previous minimum repayments plus the extra $60.70 they were able to budget, a total of $1,655 per month and pay off your mortgage. This would mean they would clear their mortgage in only SIX more years instead of TWENTY-SEVEN YEARS.
Can you see just what an amazing difference an extra $60.70 per week could make with a little money management?
The table below summarises their position without the impact of their budgeted additional repayment:
|
Debt |
Yr 1 – 5 |
Yr 6 - 10 |
Yr 11 – 30 |
|
Mortgage |
877 |
877 |
877 |
|
Credit card |
72 |
72 |
- |
|
Furniture loan |
111 |
- |
- |
|
Car loan |
332 |
- |
- |
|
Total |
1392 |
949 |
877 |
This new table show the impact of repaying an additional $60.70 per week, or $263 per month:
|
Debt |
Yr 1 |
Yr 2 |
Yr 3 |
Yr 4-9 |
|
Mortgage |
877 |
877 |
877 |
Paid off Yr 9 |
|
Credit card |
Paid off Yr 1 |
- |
- |
- |
|
Furniture loan |
111 |
Paid of Yr 2 |
- |
- |
|
Car loan |
332 |
332 |
Paid off Yr 3 |
- |
|
Total |
1655 |
1655 |
1655 |
1655 |
It is easy to see that if you could increase your payments by even a little, it makes a huge difference.
Q. So, the big question is where does the extra money come from?
A. The answer is simple, either additional income or more efficient spending habits.
You should always be aware of your financial situation, and it is important to keep your records up to date and change them as necessary.