Question No. 1: Do you have an emergency fund?
You have a refund check in one hand and a stack of credit card bills in the other. Do you wipe out card debt? Build up savings? Something else?
“It depends on where the money is going to do the most good,” says Bruce McClary, spokesman for the National Foundation for Credit Counseling.
Here are the five questions to ask yourself before you decide what to do with that refund check:
Question No. 1: Do you have an emergency fund?
Setting up an emergency fund “is probably the most important thing to look at first,” says Beverly Harzog, author of “The Debt Escape Plan.” From job loss to unexpected bills, a little cash cushion can absorb a lot of life’s shocks. Aim for six months’ net income in savings, she says.
Your refund isn’t that big? Worry not. It’s not all or nothing. Even a few hundred in savings can take care of an unexpected bill or two. For those living on the financial edge, that’s huge.
No emergency fund? “Put at least $1,000 in savings,” says Trent Hamm, founder of TheSimpleDollar.com. Then put the rest toward your debt.
Andy Byron, a financial planner and principal with HC Financial Advisors, agrees. “It’s your safety net,” he says. “You’ve got to have a safety net.”
To maintain that momentum, put saving on autopilot, says Byron, even if it’s a small amount. “It’s amazing what a little bit on a regular basis can do.”
When you have that tax refund check in your hand, analyze what’s really best for you. “A savings account may not be putting itself front and center the way a debt collector may be,” says McClary.
What you might not realize: Putting that refund into savings will ultimately benefit your cards, even though it doesn’t directly impact your credit score, he says. “If you’re living close to the edge and not setting aside money, you are putting those cards at risk.”
Question No. 2: What is your debt costing you?
It comes down to lost opportunities. What is that pile of card debt preventing you from doing? How much are you paying for the privilege?
“High interest rates are toxic,” says Harzog.
A savings account may not be putting itself front and center the way a debt collector may be.
|\u2014 Bruce McClary|
National Foundation for Credit Counseling
If you make minimum payments every month, you may not realize just how much you are paying. Take each card balance and multiply it by the APR. If your rate is 20 percent, multiply your current balance by 0.20.
“That’s how much it’s costing you each year,” says Hamm. Your money is “disappearing, and you’re getting nothing for it.”
Look at it another way: If you can wipe out a debt that’s costing you 12 percent, “That’s a no-brainer,” says Byron. “That would be like earning 12 percent. Where else can you get 12 percent?”
When calculating costs, don’t forget the emotional toll. “For most people, the emotional response carries the most weight,” says Hamm.” If you have negative feelings when you go to the mailbox or open an email,” that’s a cost, too.
Question 3: Are you maxed out on a card?
If you have a balance that’s at or near your credit limit, you are hurting your credit score and denying yourself use of a card you might need for an emergency. In that case, McClary says, the benefit of directing your tax refund to pay off that balance would be significant.
Lowering the balance on an out-of-control card would boost your credit score, which can cut the price on everything from insurance premiums to phone plans.
Question 4: Which cards should you pay off first?
From a strictly mathematical standpoint, slaying the debt with the highest APR gives you the most bill-killing power.
“Tackling the highest interest rate will give you the most progress,” says Hamm. So instead of paying off a smaller card or two, you could make a larger balance drop significantly. And watching one card bill go from $5,000 to $2,000 “feels pretty good,” he says.
But when it comes to keeping yourself motivated over the long haul, it could be more effective to pay off the card with the lowest balance first, says Remi Trudel, marketing professor with Boston University and part of a four-person team researching consumer debt repayment and motivation.
“Paying the smallest account first – that’s what we find is most motivating to people,” he says.
You’ve got to have a plan. It doesn’t have to be down to the penny, but you need to understand where your money is going.
|\u2014 Andy Byron|
HC Financial Advisors
Typically, Americans carry four or five credit cards with nearly identical interest rates, says Trudel. “In our experiments, concentrating their repayment to a single account led them to repay their debt 15 percent more quickly.”
Question No. 5: How are you going to stop this cycle?
No one gets out of debt by accident. “You’ve got to have a plan,” says Byron. “It doesn’t have to be down to the penny, but you need to understand where your money is going.”
His pick: A budgeting app such as Mint can help track spending. It takes about half an hour to set up and you see where your money is going, he says.
No matter whether you go digital or pen and paper, write down the balance total and APR for each card, “so you can get a feel for what the numbers look like,” says Harzog. “Visual cues are important.”
While you’re at it, if your credit is good, consider a balance transfer card, she says. That way, every dollar of your refund goes to principal, not interest.
Finally, consider whether you control your spending, or the other way around. If the latter, “Lock up your credit cards for a while,” says Hamm. “Learn to spend based on what you’ve got in your checking account. Don’t use your credit card at all.”
“It really comes down to understanding where your money is going and planning for the unexpected,” says Byron. “Because that’s life.”