If you’re among the lucky taxpayers expecting a sizable refund this year, you might find yourself mentally spending it before the direct deposit hits your account. It’s fun to fantasize about that pair of designer boots, the latest video game console or a weekend in Vegas, but stop right there.
If you’re carrying credit card debt, it’s in your best interest (pun intended) to use your “gift” from Uncle Sam to reduce your balances. In fact, a January survey by tax prep and software company TaxSlayer found that more than one in three people (37%) plan on doing just that.
Here are a few reasons why it’s worth considering.
1. The Savings Are Exponential
When you pay off a large chunk of debt, you’re not only lowering your balance, but you’re also reducing the overall cost of borrowing. “You can pay off the rest of the balance faster and save a lot of money over time that would have gone to interest,” says Bruce McClary, senior vice president of memberships and communications at the National Foundation for Credit Counseling.
Let’s say you have about $5,000 in debt with an interest rate of 24.99%. If you’re only able to afford a $150 payment each month, it would take you 55 months and cost you an additional $3,418 in interest to make the full payoff.
Now let’s say you cut that debt in half to $2,500 using your tax refund. That same $150 per month payment will allow you to pay off the rest of the debt in 21 months and will cost just $603 in interest.
Put another way, using your tax refund to take $2,500 off the balance will save you $2,815.
[Read: Best Credit Cards.]
2. You Can Boost Your Credit Score
One of the big things credit scoring algorithms take into account is how much debt you have relative to the debt available to you. This is known as credit utilization, and it is the second-biggest factor in your credit score (behind making payments on time), accounting for 30% of your FICO score.
“If your balances are close to your credit limit or over the recommended 30% debt utilization level, any progress toward lowering those balances can have a positive effect on credit score,” says McClary.
3. You’ll Bring Financial Stress Levels Down
One of the questions that Rob Burnette, CEO, investment advisor representative and professional tax preparer at Outlook Financial Center in Ohio, asks his clients when they are discussing how to spend a windfall is “If you pay off that debt, what would it do for you?” For many, he says, the answer is, “It will provide great emotional relief.” The impact of financial stress on your mental health and overall well-being can be significant, so anything you can do to reduce that strain can make your life better.
“The psychology behind this is real,” says McClary. “Significant progress in a short period of time can give you wind at your back to motivate you to do things to continue that progress. Something like this can be a game changer.”
4. You Can Free Up Cash to Invest in Yourself
Paying down chunks of high-interest debt can give more financial flexibility in your budget, McClary says. Being saddled with credit card bills comes with an opportunity cost because that’s money you can’t use to fuel your other goals.
With reduced debt, however, you can reallocate some of your available income to galvanize your financial future, whether it’s increasing your 401(k) contribution or taking a course that could advance your career.
[Read: Best Balance Transfer Cards]
Should You Use the Whole Tax Refund for Your Credit Card Debt?
Before allocating your windfall, consider the bigger picture. “It’s easy to get excited when you get money you weren’t expecting and you need to fill some gaps in your budget, but it’s important to take a moment to think about how to best use what you just received,” says McClary.
His advice: Think about your needs before you think about your wants. “Look at your budget and see where you might apply that money for the most impact,” he says.
Paying off credit card debt would certainly qualify as a “need,” but you can also leave room for other priorities, Burnette says. He recommends having a plan for when any large chunk of money hits the household, whether it’s a tax refund or a bonus.
“Your plan might say take half of it and apply it to any credit card debt I’ve got,” he says. “Then another percentage can be for other financial goals like retirement, savings for a down payment on a house, etc. Be thoughtful about it.” One more thing: Allocate a small percentage of the money for something fun. “You’ve got to live,” he says.
If you’re getting a $3,000 refund, it might look something like this:
— 50% toward credit card debt: $1,500
— 25% into your short-term savings account: $750
— 15% to contribute into your individual retirement account: $450
— 10% for new sneakers and a day out at a baseball game: $300
Of course, you can adjust those percentages according to your specific situation, but do your best to stay close to your preset boundaries.
Other Smart Uses for Your Tax Refund
While paying down credit card debt has many benefits, don’t overlook these equally smart uses for a tax refund.
Build Up an Emergency Fund
Having an emergency savings fund is critical to keep you from getting further into debt. “An emergency can throw your budget off in a nanosecond if you’re not prepared,” McClary says. Start one with your refund, and then contribute regularly with small automatic deposits every payday.
Knock Off an Old Collection Account
Old debt collection items that are on your credit report can cause damage. “It’s a good idea to pull a copy of your report and do a little bit of cleanup, and a debt collection account is one of those things,” McClary says. Not only can paying it off have a positive impact on your score, but it can put your mind at ease knowing you’ve taken care of something that’s been hanging over your head.
Fix Something Before It Gets Worse
When money is tight, it’s hard to pay for routine maintenance like dental appointments, fixing a leaky roof or replacing the brakes on your car. But if you have enough in your refund to take care of some or all of those things, it’s a good idea, says McClary. “Small issues now could evolve into bigger issues, and you don’t want that to happen with a big-ticket item like your house or car, or with your own physical well-being,” he says.
[Read: Best Debt Consolidation Loans.]
Watch Out for the Tax Refund Trap
Tax refunds can feel like a godsend when you’re cash-crunched, but in reality, getting them isn’t ideal.
“If you’re getting a large tax refund, it means you’ve giving an interest-free loan to the federal government,” says Burnette. You’d be better off reconfiguring your tax withholding so you can have more disposable income throughout the year. However, Burnette says that not everybody has the discipline to put those funds to good use, and some prefer to use a tax refund as a forced savings plan.
If you are using the refund to pay down credit card debt, it’s also important to realize that it isn’t going to solve all of your problems, says McClary. “It may give you temporary relief, but if there are other issues that are continuing to get in the way of making timely payments and keeping your debt manageable, you really want to take the extra step to take care of those things,” he says. You might reach out to a nonprofit credit counseling agency like the NFCC for guidance.
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4 Reasons to Pay Off Credit Card Debt With Your Tax Refund originally appeared on usnews.com
