Debt needs to be paid off, you have no other option, but you can choose the way to pay it off. If you have a certain amount of money to pay off a portion of your debt each month, you can choose to allocate any extra cash on the highest interest rate debt or the highest amount debt. Both serve the same purpose of paying off your debt, but which one is better? If I were you, I would choose the method that can help to pay off my debt faster and with less total interest.
In fact, there is an approach that can help you pay off your debt faster and with less interest. This approach is called Debt Avalanche. By paying your debt using debt avalanche approach, you will pay off your debt faster and pay less total interest to your creditors. How it work?
To use the debt avalanche approach, what you need is a list of interest rate of all your debts. Let make it simple by assuming all debts have the same tax liability, but if you want to compile for your debts that have different tax liability, then you need to determine the debts' interest rate after taxes. You will need these interest rates for calculation in debt avalanche approach. Below are the steps involve in the compilation and calculation on which debt to pay more in debt avalanche approach so that you save money in term of interest and be debt free faster:
Step 1: Order your debts with highest interest rate to lowest.
List your debts on a paper (or spreadsheet if you use software) according to the interest rates, sort them from the highest interest rate to the lowest. Normally, credit cards will be ranked higher as typically credit card interest is 10% to 20% or more. Then, personal loans may be your next highest interest rate loan followed by auto loan, mortgage and home equity loan. Don't border about the balance of each debt, it will not be used in this debt avalanche approach.
Step 2: Pay minimum due on each debt
Then, add a column on your list or spreadsheet for the minimum amount need to be paid each month. This is the amount you need to pay toward each debt, except the one on the top list. Then, compile the list for the total minimum amount that you need to pay for that month.
Step 3: Pay extra cash toward the debt at the top list
In order for the debt avalanche approach to work, the money you prepare to pay your monthly debt should have a bigger amount than the total minimum month due for all your debts. Pay only the minimum due for all your debt except for the top listed debt which has the highest interest rate. Allocate the extra cash (the money you allocate for your debt minus the minimum monthly due on each debt) to this highest interest rate's debt, the top one on your list.
Step 4: Repeat every month
By paying the minimum due each month, you are meeting the payment requirement of every creditor. And at the same time, you hone in on only your debt with the highest interest rate. Repeat step 1 to step 3 every month, you need to re-order your list if your debt interest rate has changed. Remove from the list if the debt had been paid off (it might not be the debt on the top list if other amount is smaller).
If you record your payment each month, you will notice a significant amount save in term of interest and the time frame to pay off your debt is shorter. You can do a simulation in spreadsheet software if you want to know how effective the debt avalanche approach helps in paying off your debt faster and save in total interest.
Summary
Debt avalanche approach is mathematically the best method for paying off your debts. It helps to get rid your debt faster with less total interest.
Source: http://www.ArticlePros.com/author.php?Cornie Herring
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