Using Your Tax Refund to Pay Off Debt
While it might be tempting to spend your refund on something fun, here are three reasons why paying off outstanding debt could be a better move.
Tax season is here (hooray?), and with it, the possibility of receiving a chunk of cash in the form of a tax refund (hooray!).
According to the IRS, an estimated $307 billion will be refunded in 2020, with 72% of consumers who filed a tax return receiving an average refund of $2,781 in 2018.
Assuming you do receive a check or direct deposit, the next question is: What to do with all that dough?
Shopping spree? A massage? Margaritas on the deck of a cruise ship? Why not – you deserve it!
But there’s good reason why a majority of people plan to spend their refund on financial goals, with 34 percent opting to pay off outstanding debt, such as student loans, medical bills and credit card balances, according to NRF’s 2019 Tax Return Study.
Here are a few of the reasons you might consider using your refund to pay off debt this tax season.
1. Reduce Interest Costs
While carrying debt around might mean you have more money to spend now, it can also mean accruing interest at alarming rates.
Interest Gets Expensive, Fast
If you have a high interest rate, paying the minimum balance can get expensive fast, adding up to thousands of dollars more than the original amount.
According to the Federal Reserve, consumers racked up $870 billion in credit card balances in 2019, paying more than $113 billion in interest alone. That averages out to about $5,560 in interest per person.
Interest charges don’t buy you anything except the ability to pay slowly – so if you can afford to pay faster, it is usually in your benefit to do so.
Extra Payments Go a Long Way
If your account is accruing interest, putting any windfall money or extra “chunks” of cash towards your principal balance can save you large amounts of money in the long run.
If you have more than one debt on your plate, paying off the debt with the highest interest rate first is one strategy financial advisors may recommend for reducing your overall costs while working towards your financial goals (experts call this the avalanche method).
When it comes to extra payments, a little can go a long way. You can even use a loan repayment calculator to see how far your “little extra” will go.
Sample Case – Student Loan Interest
An average student has a loan balance of $30,000, at an interest rate of 8 percent and a repayment term of 10 years.
Making an average monthly payment of $363.98 over 120 months, the grand total for the loan after interest comes to $43,678.14.
By paying a mere $25 per month more, that student can save $1,417.72 in interest over the life of the loan and shorten the term by almost a year.
But if you can’t afford to pay a little extra each month – or want to pay more – using your tax refund to pay a big chunk is a good way to reduce the total amount you’ll owe, without hurting your budget.
2. Potentially Improve Your Credit Score
Paying debt could help with your overall financial fitness, including your credit. Talk to your financial advisor to find out if paying down your debt will help improve your credit score.
Lower Credit Utilization Ratio
One of the key factors in calculating credit scores is the Credit Utilization Ratio, or the amount of available credit you are using. For example, if you have $10,000 available, but only use $1,000, you have a credit utilization ratio of 10%. In general, a lower ratio is better for your credit score, so paying off part of your balance could be a boost.
Reduce the Number of Accounts
Another factor that affects credit score is the Number of Accounts that have balances. In general, having more accounts with a balance reduces your credit score. If you can pay off one debt completely, you’ll have fewer open accounts, and it may help improve your score.
3. Pay Off Debt Faster
In addition to reducing interest costs, making extra payments will reduce the overall burden of your debt and bring you that much closer to financial freedom.
When you pay off debt faster, you can put yourself in a stronger overall financial position. The money that was going towards monthly payments becomes available for other uses, such as building savings, creating a retirement fund, paying off other debts… or simply going on more vacations, if that’s your goal.
Remember our average student from before, paying $363 per month for their student loan? By paying off that loan, that student will have an extra $4,356 a year in their budget.
So, while you might not have as much cash-on-hand now, it can be helpful to think of your extra payment as an investment in your financial future. One that can have a significant pay-off once your debt is finally eliminated.
Eliminating debt can also bring incredible peace of mind.
According to a 2020 CreditWise survey, 73% of Americans rank finances as the #1 stress in life – more than politics, work or family.
Even when it doesn’t make the best financial sense, some people choose to pay off their debt sooner to avoid the stress of being in debt.
While we’re not recommending that you drop all other concerns to pay off your debt faster, stress is an important factor to consider while you are making your list of pros and cons.
Ask yourself: How much would happier would I be without this debt?
If you’re a person who is constantly worrying about finances, having one less payment can make a huge difference in your quality of life.
Your Refund, Your Choice
In the end, the decision of what to do with your refund is yours and yours alone. But do the math, and you may find that having less debt is a much better way to treat yourself than a massage or a margarita.
*The information provided on this website does not, and is not intended to, constitute financial, tax or legal advice; instead, all information, content, and materials available on this site are for general informational purposes only. Information on this website may not constitute the most up-to-date legal or other information. You should consult your own financial advisor, tax specialist or attorney for advice regarding your individual circumstances and needs.