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Which Debt Should I Tackle with My Tax Refund?

Erica Sandberg

February 12, 2013

QDear Erica,

I'm getting a tax refund. I can pay off my car loan with it, but I'm not sure I want to because then I'd only have about $500 in savings. I don't like going under the $1,000 mark. I have a credit card with a limit of $10,000 (I owe only around $700), and I try not to use it if I don't have to. My husband says I should pay off the car loan, but we have other debts to pay, and I worry that not having enough in the savings account would force me to use my card. What would you recommend? Am I wrong for wanting liquid cash in the bank and not using the credit card if we don't have to? What would you do? — Amy

AHi Amy,

I totally get why having a sweet stash of cash is important to you. It is to me as well. Funds in a savings account have an undeniable feel-good factor that can't be replaced with a credit line, however substantial it may be. It provides peace of mind because it's your money, not a bank's. You are free to access it any time at no cost. If an unexpected expense comes up — be it a fun opportunity like a vacation or serious one like essential home repairs — you don't have to forgo the experience or go into debt for it.Ask Erica

The again, you also need to be sensible, and sometimes that means letting go of purely emotional ideas. Look at your financial picture wholly and logically. If a lender is charging you interest, you're wasting your money by not paying it down or off when you could. Even if a creditor isn't adding extra fees, there might be negative consequences to not paying. Your letter doesn't indicate you're worried about not being able to pay, but, if your financial situation changes, you may be glad you whittled down your big debts.

For these reasons, I think you should use at least some of the tax refund to reduce the most important liabilities.

You and your husband should get together and plan for what should get paid down and in what order. List all debts. Then rank each by the interest rate. If the difference between two debts' interest rates is negligible, order them based on the worst thing that would happen if you were unable to meet the payments. Here is an example of some debts you might have, in order of sample interest rates:

Type of debt Interest rate Consequence for not paying
Credit cards 18% Collection activity, lawsuit, judgment, post-judgment collection actions
Owed income taxes 8% Wage garnishment, property levy
Student loans 5.6% Long-term credit damage, collection action, tax refund interception, wage garnishment without lawsuit
Car loan 5% Repossession, deficiency balance (if the lender sells the repossessed car for less than the remaining balance)
Home mortgage 3.5% Foreclosure
Medical bills 0% Collection activity, lawsuit, judgment, post-judgment collection actions
Friend loan 0% Relationship damage

After taking stock of your debts, decide which of the lenders really ought to be satisfied first. It could be the car loan. Then again, after looking at your other debts' interest rates, you may choose to send more to another that lender first.

So how much cash would be best for you to have in your savings account while you're in the repayment process? Start with around three to six months' worth of your essential expenses tucked away. That time frame could be shorter if no one is depending on you for financial support. Add at least a month's worth of expenses for each additional dependent. If you'd prefer your savings account balance to be higher, keep in mind that it'll be easy once the car loan is paid off — you can simply reroute those loan payments into your savings account until it reaches a level you're comfortable with.

As far as not wanting to lean on plastic to ease the pain of financial falls, I'm right there with you. When you treat credit cards as payment tools and very short-term debt instruments, you'll never have to include them in your debt-repayment chart when times get tough.

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