Explain why paying off the highest-rate debt first saves the most interest.
Open the page you put together in lesson 6.1, "Rank your debts and clear the expensive ones first", from the course "The Singapore personal finance system". Beside each debt on it, write its interest rate: the EIR for any loan and the statement rate for any card. You'll use those rates, together with the figure for this month's extra repayment money that is already on the page, to decide which debt gets your spare money.
Mei Ling has three debts on their page and about S$264 of extra repayment money this month (an invented example, as are all of Mei Ling's figures). They plan to divide the S$264 into three equal parts so every balance goes down at the same pace, which is what most people want to do when they first look at several debts at once.
Dividing spare money equally across your lenders seems fair to each of them, but it is the slowest and costliest way to repay. It assumes a debt charging 26% and a debt charging 6% cost you the same amount to carry.
Every extra dollar you repay stops attracting interest at the rate of whichever debt it goes to. An extra S$100 on a card at 26% cuts your interest by about S$26 a year, while the same S$100 on a plan at about 6% cuts it by about S$6 a year (illustrative figures). In lesson 6.1 you saw that clearing a debt at a certain rate works like earning that rate with no risk attached. Putting money against a 26% debt earns you 26% risk-free, so your extra money should go there before it goes anywhere else.
The avalanche method has two rules. Pay at least the minimum on each debt every month, on time. Then put all your extra repayment money on the one debt with the highest interest rate, and pay nothing above the minimum on the others.
Once that top debt is paid off, its whole payment, minimum and extra together, is added to what you already pay on the debt with the next-highest rate. You carry on down the list in the same way until nothing is owed. The method is named after this build-up: every debt you clear releases its payment to the next one, so each debt further down the list receives a larger monthly payment than the one above it did.
Sorting your debts takes three steps. Write down every debt you have. Look up each rate, using the EIR for loans and the statement rate for cards. Then put them in order of rate, highest at the top, without looking at the balances. A debt of S$500 at 26% sits above a debt of S$20,000 at 4% (example figures).
In rate order, Mei Ling owes S$9,000 on a credit card at 26%, S$6,000 on a personal loan at 8%, and S$1,500 on a sofa instalment plan at 6%. Their budget for debt is S$800 a month.
They pay S$200 a month on the loan and S$60 a month on the sofa plan, and the card gets the remainder. In month 1 the card receives about S$540 (S$800 - S$200 - S$60 = S$540), made up of the card's minimum of about S$276 plus the S$264 extra (S$276 + S$264 = S$540).
Month by month the card balance drops, so its minimum payment drops too and a bigger share of each payment counts as extra. Whatever is left from the S$800 still goes to the card, and the card is paid off in month 21. In month 22 the S$540 switches to the personal loan and is paid on top of the loan's own S$200. The loan and the sofa plan are both finished in month 25.
Mei Ling's interest across all three debts comes to about S$3,033. Around S$2,287 of it is charged on the card and roughly S$746 on the two loans. Lesson 6.4, "Run avalanche and snowball on a worked example", sets out the month-by-month model these numbers come from.
The card accounts for most of the interest because it has the highest rate and stays on the list the longest. Sending every extra dollar to it saves the most per dollar, and because the expensive balance falls fastest, a smaller part of what you owe is charged at the top rate each month. Mathematically, no other order of repayment on the same monthly budget saves more interest, and this is the full case for the avalanche.
The drawback is how long you wait to see a debt disappear. The biggest, most expensive debt may need many months to clear, and until it does, the number of debts on your list stays the same. Mei Ling sends every extra dollar to the card for 20 months, and their list still shows three debts for close to two years. During that time the loan and the sofa plan go down only by their minimums, and the card falls slowly in the early months because its rate is high.
A repayment plan saves money only if you keep to it, and many months without visible progress wear down motivation. Some people stop partway or slip back into splitting their money evenly, and give up much of the interest they would have saved. These habits make the wait easier:
Keep a chart of the target debt's balance each month so you can watch it go down. Pick milestones to mark, for example the card balance falling below S$5,000. Pay by standing instruction from your bank account, so each month's payment goes out without you having to decide to make it.
If past experience tells you that you need early wins to keep going, consider the snowball method as the alternative. Lesson 6.3, "The snowball method: smallest balance first", covers it next.
Take your page from lesson 6.1 now and re-sort it by interest rate, highest at the top, using the EIR for every loan and the statement rate for every card. Read from top to bottom, the list gives you the order in which you would pay off your debts under the avalanche method.
Sort your debts by interest rate, highest first, and write down the order you would pay them off under the avalanche method.
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