Although debt financing has made it possible for many people to live their dreams by providing immediate funds for initiatives they otherwise would never have been able to afford, the mountain of debt for contemporary Americans is quite impressive. The average American is saddled with over $92,000 in debt, and most have no idea how to make that figure more manageable. Fortunately, a waterfall debt payoff plan may help ease the burden.
A waterfall debt payoff plan is a structured approach to paying down debt in which the highest-tiered creditors are paid off first, in full, before lower-tiered creditors are repaid. Using the waterfall approach, loans with the highest principal balances are paid off first, with smaller loans getting what trickles down.
The idea behind the waterfall debt payoff plan is that by paying back the largest loans first, debtors significantly impact their creditworthiness by showing they can pay back a major loan. In this article, we’ll discuss waterfall debt payoff plans in greater detail, including how they work, their benefits, how to set one up, and how other structured approaches to debt repayment differ.
How a Waterfall Debt Payoff Plan Works
The waterfall debt payoff plan works by using a tiered approach to debt repayment. In most cases, the highest-tier debt in a waterfall plan is the debt with the highest outstanding balance.
Using the waterfall debt payoff plan, the highest-tier debt is given top priority. After the monthly minimum is met for all outstanding debts, any remaining funds that can be applied to paying down debt are contributed completely to the highest-tier balance.
When the highest-tier debt is paid in full, any remaining funds are contributed completely to the next largest debt on the ladder. This differs from the approach taken by most debtors, who divide their payments up among their outstanding balances and try to repay them simultaneously.
The Waterfall Analogy
The waterfall analogy helps explain how this particular type of debt payoff plan works: Imagine a series of buckets aligned vertically under a waterfall. The largest bucket is at the top of the vertical string, with the buckets getting progressively smaller as the chain of buckets goes down.
In this analogy, the buckets represent the debt to be collected, while the waterfall represents the funds contributed toward debt. As the water pours down, the largest bucket at the top of the string catches all of the water, with none of the lower buckets able to collect water until the largest bucket at the top is filled and moved out of the way.
Example of a Waterfall Debt Payoff Plan
Using the waterfall analogy, let’s create a hypothetical scenario in which a person has the following debt breakdown:
- Credit card – $5,000
- Home equity line of credit – $40,000
- Student loan – $25,000
- Personal loan – $10,000
- Auto loan – $20,000
The total of this debt is $100,000, but it does not all carry the same weight when using the waterfall payoff plan. The tiered debt would breakdown as follows:
- Home equity line of credit – $40,000
- Student loan – $25,000
- Auto loan – $20,000
- Personal loan – $10,000
- Credit card – $5,000
Now, let’s assume that after all monthly bills are paid (including monthly minimums for all debt), the person has $2,000 leftover to pay down debt. The entire $2,000 would go toward paying down the HELOC and not divided five ways among all outstanding debt. Any windfalls (i.e., stimulus checks) would also be contributed in their entirety toward the HELOC until the HELOC was completely paid off, moving the student loan to the top tier of the waterfall.
Some may notice that by using this approach, the HELOC balance will eventually become less than the student loan before it is completely paid off. So, would this cause the HELOC to move to a lower tier?
No, the HELOC will remain on the top tier until it is completely paid off, regardless of how small the balance gets. As it was the largest original loan, the idea is to get it paid for in its entirety, showing the ability to pay back a significant loan instead of paying small amounts on all loans indefinitely.
Waterfall Debt Payoff Plan vs. Debt Avalanche
Waterfall and avalanche are both terms for powerful forces of nature, but they are not the same for debt repayment. While the waterfall approach tackles the highest-principal balance first, the debt avalanche focuses any extra funds for debt repayment on tackling those balances with the highest interest rates, regardless of total loan size.
Using the example mentioned above with the debt avalanche strategy, a $5,000 credit card debt at 18.99% would take priority over the $40,000 HELOC at 6.5%.
Waterfall Debt Payoff Plan vs. Debt Snowball
The debt snowball is essentially the exact opposite of the waterfall payoff plan. It eliminates the smallest account balances first, moving to the next largest down the line until the largest balance is paid off last.
Using the same example, the tiers for a debt snowball would go:
- Credit card – $5,000
- Personal loan – $10,000
- Auto loan – $20,000
- Student loan – $25,000
- HELOC – $40,000
Advantages of a Waterfall Debt Payoff Plan
One major benefit of the waterfall plan is that it allows people to get their largest balances paid off first, increasing their creditworthiness by showing the ability to pay back major loans.
Another advantage is that as large principal loans are usually the most expensive (even at lower interest rates, the total interest is still likely to be higher when charged against more principal), the waterfall plan allows debtors to tackle a significant chunk of principal with each payment, reducing the amount against which costly interest can be charged.
Disadvantages of a Waterfall Debt Payoff Plan
The waterfall payoff plan’s main disadvantage is that leaving lower-tiered balances untouched while focusing on the highest tier balance can seem counterintuitive. For example, suppose a person has $5,000 to contribute toward debt repayment on a given month. In that case, it may not make sense to put that toward the highest balance if it could be used to close a smaller balance, ending interest charges for the zeroed-out account.
It can also be argued that the waterfall plan works better for businesses trying to repay debt than for individuals. When individuals don’t have much money each month to put toward debt repayment, some financial coaches would argue that it is better to prioritize smaller accounts in a “win-small-battles-first” approach instead of getting frustrated by the seemingly nonexistent progress they are making by chipping away at the highest-tier accounts.
How to Set Up a Waterfall Debt Payoff Plan
The waterfall debt payoff plan can be either an individual strategy for tackling debt, in which individuals simply use all of the funds from their debt repayment cash wallet to pay down their highest-tiered account each month, or it can be a contractual obligation extended by creditors as a precursor for getting approved for a loan.
In fact, the waterfall plan has strong roots in creditors issuing sizable loans only under the condition that their loans be paid back before any other debts are paid.
What Should Be Included in Waterfall Debt Payoff Plans?
A mortgage should not be included as part of a waterfall payoff plan. As it is the largest debt for most Americans, it would be the highest-tier using this approach, but it is not included because it is “good debt.”
A “good debt” is described as debt used to build wealth or increase income over time. As such, a mortgage is the king of good debt, as each payment helps a homeowner build equity over time. The more payments made on a mortgage, the more cash in the homeowner’s pocket upon sale of the home.
Student loans have traditionally been considered good debt, but that is changing with the rising costs of higher education and the increasing number of people working in fields unassociated with their degrees.
If student loans are manageable and used to land higher-paying jobs in the area of the degree, they can be considered good debt; if large amounts of loans are taken out with no specific career in mind or used for a degree never completed, they become bad debt. When using the waterfall debt payoff plan, only bad debt should be included.
Conclusion
The waterfall debt payoff plan is an approach to debt repayment in which the highest-tiered debt is paid off in its entirety before the lower-tiered debt is considered. When using this strategy, the highest-tiered debt is that with the largest overall value, making it the most expensive loan.
This is a good approach when a debtor wants to make significant principal payments and improve their creditworthiness by demonstrating the ability to pay back a major loan.