Got a tax refund? Then get out of credit card debt! By Ben Woolsey
If you are a savvy taxpayer and have already filed your tax refund, you are to be commended. An alarming number of filers wait until the 11th hour to stand in line at their central post office drop-off window and sneak their payments in under the wire. But if you are eligible for a refund, it only makes sense to file as early as possible, right?
Assuming you are one of the lucky Americans who will get a tax refund this year, it may be tempting to take your refund to the track or the mall. Financial experts have another suggestion: Stop and examine your credit card debt situation.
According to the Federal Reserve's 2007 triennial Survey of Consumer Finances, about 46 percent of American families carry a credit card balance, with a median balance of $3,000 and an average balance of $7,300. In 2008 the average tax refund was $2,436. so there is clearly an opportunity to exercise some discipline and apply this windfall to the large gorilla sitting in the room. Even if this leaves a large amount of credit card debt, at least it's a step in the right direction.
Maury Randall, professor and chair of finance at Rider University, agrees that it's wise to use tax refunds to combat credit card debt. "I even tell my students that before you put anything in stocks and bonds, one of the best investments you can make is to pay off your credit card debt," Randall says. "It's a risk-free return, and not only that, but the interest you pay on credit card debt is not tax deductible. And putting your refund toward debt is probably the best investment you can make if you have a large amount of outstanding debt, unless there is something else incredibly important that you need to spend the money on."
Becoming debt free usually requires numerous steps, starting with changing the fundamental behavior of spending money you don't have. You can't start chipping away at the debt until you stop building it. And if you add a big tax refund, it can be like double dose of dynamite blasting away a chunk of that mountain of credit card debt.
With the average credit card rate hovering around 14 percent, consumers pay dearly for last month's (or last year's) spending party. The financial headache lingers unless you confront the enemy. Increases in 2005 and 2006 in minimum credit card payments required by banks and credit card issuers have helped force consumers to at least start attacking the principal of their outstanding balances, if only a tiny bit at a time. While it might have taken 30 years of paying only minimums to get out of debt before, it now takes only 15 years. But that's still a ton of money when you think about all the interest paid on those original, if ill-advised, purchases.
Sky-high interest rates are another incentive to get rid of that debt as soon as possible. "Interest rates are quite high on credit card debt and you can't typically get the return that the credit card company is charging you," Randall says. "Putting your refund toward debt is a safe return -- every time you pay your credit card debt, you know for certain that you'll be saving that interest expense."Other prudent steps to get out of credit card debt and becoming debt free include transferring balances over to a 0 percent APR credit card (such as a balance transfer credit card) or some other type of debt consolidation loan. Then you can apply all of your future payments to the principal and not have to waste any more on interest.
Tax refunds are always a welcome surprise this time of year. Be sure to use yours wisely.
Published: April 2, 2006
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