Should I Use My Tax Refund to Pay Off Debt?

Sorting home finances

Is it a good idea to use your tax refund to pay off debt? It very well could be. Paying down your credit card or loan balances can save you money on interest, reduce your monthly debt payments, boost your credit score and free up your credit lines.

Using your tax refund to pay off debt may be a good idea, but is it the best use of your money? That depends on your personal situation and priorities. Let's take a closer look at the pros and cons.

What Are the Benefits of Using Your Tax Refund to Pay Off Debt?

Although there are differences between paying off credit cards and paying off loans, here are four good reasons to consider using your tax refund to pay off debt:

  • You'll save money. Credit card interest can be high. If your credit card has an annual percentage rate (APR) of 25%, paying off $2,000 in debt now will save you roughly $500 in interest over the next year. Paying off your car loan or making an extra payment may save you less in interest; these types of loans typically have lower interest rates, and the amount of interest you owe tends to dwindle as the loan nears payoff. Still, money saved is money saved.
  • You'll reduce your monthly expenses. Lower credit card balances mean lower minimum monthly payments. Paying off a card balance or loan entirely translates into one less bill to pay, month after month. That's money you can put toward savings or other needs. Don't have enough to pay off your whole loan or card balance? Set the money aside and use it to make or supplement your monthly payments. That'll increase your chances of making all your monthly payments on time, which is a win for your credit score.
  • You may increase your available credit. Lowering your credit card balances will raise the amount of credit you have in reserve. And while it's better to have some cash set aside in an emergency fund for unexpected expenses, available credit can help you in a way that a maxed-out credit line cannot.
  • You could improve your credit score. We'll cover more specifics on this in a moment, but in a nutshell, paying down revolving debt such as credit cards helps your credit utilization ratio, which can boost your credit score.

The main downside to using your tax refund to pay off debt is that you can't then use it for something else that needs priority. For example, if your roof is leaking and about to cave in, roof repairs might be worth considering instead. The same goes for necessary medical procedures, major car repairs, replacing the computer you use to run your business—important major purchases. Even in these cases, you might consider paying down your credit card balance, then using your card to pay for the purchase. That way, you can take advantage of purchase protections and rewards that come with your card.

How Paying Off Debt Affects Your Credit

Generally speaking, paying off debt helps your credit. At the most basic level, it marks the successful repayment of your debt—one of the very things your credit score is meant to track. But the way you use your tax refund to repay your debt can make a difference in how your credit is affected. Consider these three scenarios:

  • Bringing or keeping an account current: If you're late making payments on a credit card or loan account, or you are about to fall behind, your tax refund money could save the day. While you can't erase late payments that have already been made from your credit report—or reverse the damage they've done to your credit score—you can avoid further trouble by bringing your account current. Any leftover money can help you cover timely payments going forward.
  • Paying off an installment loan: Suppose your tax refund enabled you to pay off the rest of your car loan, personal loan or mortgage. Would that help your credit? Only somewhat. While successfully paying off an installment loan is a good thing, doing so means your loan account will drop off of your credit report. This may cause you to have a less diverse credit mix or lower the average age of your accounts, which can lower your credit score a bit. This doesn't make paying off your loan a bad idea—after all, that's the idea of a loan. But if you're looking for a way to boost your credit score quickly, this may not be the way.
  • Dissolving high-interest credit card debt: The fastest bump to your credit score would probably come from paying down or paying off your credit card balances. Paying down card balances helps reduce your credit utilization rate—which can raise your credit score. Spelled out: If your total credit card limits add up to $10,000 and you have a current balance of $2,000, you are utilizing 20% of your available credit. Pay $1,500 toward your balance, and your credit utilization becomes a score-boosting 5%.

If you're thinking about paying down credit card debt to improve your credit score, you may want to sign up for free credit monitoring. When you use it to check your credit report and score, you'll see suggestions for improving your score—for instance, by paying down your total outstanding debt or using fewer card accounts. This information can help guide you in deciding how to deploy your funds. One approach is to pay off your smallest card balance first, so you can reduce the number of accounts you're utilizing. Or you might instead pay off the card with the highest APR first, to save the most on interest.

Other Ways to Use Your Tax Refund

Paying off debt isn't the only smart financial move you can make with your tax refund. Taxpayers who don't have an emergency fund—or whose emergency funds have taken a hit during the past year during the pandemic—may want to deposit their refund checks directly into savings. A high-yield savings account may earn you a bit more interest than basic savings at a regular bank.

Contributing to your retirement account is another option. You can add up to $6,000 to a traditional or Roth IRA in 2021—$7,000 if you are 55 or older. Don't want to tie your money up until retirement? You can also start or contribute to an investment account.

Using Your Refund to Recover

These are solid financial choices in any year. But after a year that saw more than its share of financial crises, shoring up your savings, contributing to retirement or investing all have the potential to help you rebuild and recover. Using your tax refund to pay off debt is also an excellent option, especially if you stand to save significant money on interest, your credit needs a bit of a boost, or you want the psychological relief of lowering your debt and reducing your monthly payments. Your tax refund money may not buy you happiness, but it might be able to alleviate a little stress.

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