4 reasons to use your tax refund to pay card debt
By Dawn Papandrea
March 19, 2015
There’s nothing like those magical words from your tax preparer: “You’re getting a hefty tax refund this year!”
There are so many ways you could use that money, but before you go on a spending spree, you should weigh your short-term desires against your long-term financial goals.
In fact, one of the wisest uses of a cash windfall is to pay down your debt, say experts, especially the high-interest, plastic-generated kind.
“Many people sit by the mailbox waiting for that refund check to go make purchases. But the folks who are using it to pay off a piece of debt and have a strategized plan are better off,” says Brooks Stahlnecker, president of The Stahlnecker Group, a financial services firm.
Take a look at some of the reasons why putting your tax refund toward your credit card balances rather than, say, an all-inclusive vacation is a smart move:
“Many people sit by the mailbox waiting for that refund check to go make purchases. But the folks who are using it to pay off a piece of debt and have a strategized plan are better off.”
— Brooks Stahlnecker,
The Stahlnecker Group
1. It’s found money. There are few opportunities throughout the year in which you receive a large lump sum payment, especially these days when work bonuses aren’t what they used to be.
“The tax refund is special. It’s a chance to make a lot of headway in one fell swoop,” says Eric Meermann, certified financial planner with Palisades Hudson Financial Group. “The idea that it’s free cash and you should go out and spend it on yourself is an unhealthy financial idea,” he adds.
Instead, think of it as a once-a-year opportunity to take out a big chunk of debt and feel some relief, especially if you have multiple types of debt.
That being said, before you haphazardly divide up the money and click send on a bunch of payments, prioritize your debt payoff, says Meermann.
For instance, it doesn’t make sense to send a few thousand dollars toward your car payment, which might have a low interest rate, if you’re carrying a card balance with a 16 percent rate. One of the three methods of paying down debt is to tackle the debts with the highest interest rate first since it’s costing you most.
Another method, Meermann notes, is to pay off a couple of smaller bills that have been dragging on your cash flow. Erasing these debts may cause an instant surge of motivation.
2. You could get a credit score boost. One of the major metrics that goes into your credit score is the ratio of how much total credit you have available to how much you are using.
Meermann explains that if you have a $20,000 credit limit and a $10,000 balance, that’s a 50 percent debt utilization ratio. If you use your refund to pay that balance down to $5,000, your ratio drops to 25 percent. “The credit score metrics like that. The lower it is, the more it reflects that you’re a responsible user of credit,” says Meermann.
Most credit and money experts recommend keeping your credit utilization ratio below 30 percent.
Credit score improvement could be especially helpful if you plan to apply for an auto loan, mortgage or home refinance in the near future since the higher your score, the better the rates and terms you qualify for.
“Using that lump sum refund to pay down debt can reduce the amount of monthly debt payments you have, and create more monthly cash flow.”
— Eric Meermann, Palisades Hudson Financial Group
3. You’ll have extra money in your pocket each month. Once you’ve reduced your debt, you are likely giving yourself an extra infusion of cash into your monthly budget, too, says Meermann.
“Using that lump sum refund to pay down debt can reduce the amount of monthly debt payments you have, and create more monthly cash flow,” he says. The funds for that bill you no longer have to pay can then be redirected toward other debt, retirement savings or building an emergency fund.
4. You can protect yourself from future debt. Stahlnecker suggests using a portion of your refund to seed an emergency fund if you don’t already have one.
“If you’re just keeping your head above water, you have to change your lifestyle so that you don’t go right back into debt,” he says. An emergency fund is a good way to protect yourself from having to rely on plastic and ending up with a new balance if something unexpected arises.
Also, give yourself a little treat, using around 5 percent of the refund for yourself and your family, says Meermann. “A nice dinner out, for example, is OK, because it does give you a sense of not living in a completely cash-strapped world.”
No income tax refund is going to solve your financial problems, says Stahlnecker. But using it to reduce your debt will take some financial burden off your shoulders, help create a cash flow cushion and, hopefully, give you a clean credit card slate that you can commit to using more responsibly in the future.
SEE ALSO: 4 steps to bring your card debt to zero