Tax refund: Using it to pay off credit card debt
Are you thinking about using your tax refund to pay off your high-interest credit cards? It's almost always a smart move, financial planners say -- especially if you're carrying a lot of debt at a high interest rate.
But before you write that check, you should ask yourself a few key questions to make sure you're making the most of your once-a-year windfall, says Bruce McClary, spokesman for the National Foundation for Credit Counseling. After all, the average refund last year was about $2,952. "This is a great opportunity to make some headway on the repayment of your debt," McClary says. "You want to be strategic about it."
Most Americans who get a tax refund already know that paying off debt should be a priority. A 2015 survey by the National Retail Federation found that 39 percent -- more than one in every three -- planned to use their refunds to pay off credit card and other debt. It's such a popular move that the Consumer Financial Protection Bureau noted in December 2015 that a significant drop in the late fee incidence rate occurs in the second quarter every year because "consumers traditionally concentrate some of their pay down of balances in the second quarter after the receipt of tax refunds."
The following questions will help you determine how much of your refund -- if any -- you should put toward your credit card debt, which debts to pay off first and what to think about moving forward.
Do you have an emergency fund?
If you don't have at least a month of living expenses set aside, before you pay off any debt you should tuck away some of your tax refund in an emergency account you can easily access in the event of a financial crisis, says consumer credit expert Beverly Harzog, author of "The Debt Escape Plan." In some emergencies, you can't rely on your credit cards, she says. You could be the victim of identity fraud and have your access to credit temporarily frozen, for example, or you could lose your job and hit your credit limit. "Just take a little bit of your refund and put it into an emergency fund to get it going," Harzog says. "Even if it's just $100 in the account, you will feel an enormous sense of emotional relief."
Most experts recommend setting aside four to six months' living expenses. If you do have some savings set aside but not that much, you should run the numbers and decide what level of savings you're comfortable with, Harzog says. "You may be able to pay off a big chunk of your debt with your refund, lower your monthly payments and improve your cash flow," she says. "Then maybe you can commit to putting enough aside every month to build up that emergency fund."
How much is your debt costing you?
The higher the interest rate, of course, the more reason there is to pay off that debt as soon as possible. With the average credit card interest rate hovering around 15 percent (and investments averaging no more than a 10 percent return), using your tax refund to pay off that debt is almost always a no-brainer, says personal finance expert Trent Hamm, founder of theSimpleDollar.com.
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It's a different story, however, if you are one of the few who is carrying a card with a low or 0-percent interest rate, he says. If you are on track to pay off the balance before the low-rate introductory period expires, it may make more sense to build up your emergency fund, invest in retirement or pay for that car repair you've been putting off. "At a 0 percent rate, you're actually better off putting your refund in a savings account that makes 2 percent than making a credit card payment," Hamm says.
Do you have any other debts that are past due?
If you do, put your refund there first, even if it carries a lower interest rate than your other obligations, McClary says. Past-due debt carries higher fees, will negatively impact your credit rating and could lead to legal action.
"Call the company and work out a payment plan to prevent things from becoming serious," McClary says. Student loan debt that's past due, in particular, should be a top priority because the government can actually take your tax refund to repay those loans.
Which cards should you pay off first?
There's some debate about this one. To get the most bang for your buck and pay less in the long run, you should use your refund to tackle the debt that has the highest interest rate first.
But some financial experts advocate paying off the card with the smallest balance first -- called the "snowball method" -- and at least one study concurs. Researchers at Northwestern University's Kellogg School of Management found that consumers who used the less-rational "snowball" method were more likely to actually eliminate credit card debt than those who paid off the cards with the highest interest rates first.
"It's a psychological trick," Harzog says. "You end up paying a little more, but you get that quick uplifting feeling that motivates you to keep paying off your debt. The right decision for you is the one you will stick with."
How are you going to stop this cycle?
If you count on a big refund every year to pay off credit card debt, it's time to figure out how to break that pattern, Hamm says. "You're really cheating yourself because you're giving your money to the government at 0 percent interest and paying your credit card 20 percent interest," he says.
Take a look at your withholding and consider making adjustments so that you keep more of your paycheck every month. Then craft a plan to pay off the rest of your high-interest debt and use that extra money to implement it. See if you can roll over your remaining debt to a balance-transfer credit card with a lower rate.
"A windfall doesn't help that much if you're continually spending more than you earn, because in the long run you'll just wind up back where you started," Hamm says. To beat the cycle, this is a great time to truly commit to lowering your monthly spending and living within your means, he says. Then maybe next year, maybe you can spend at least part of your refund on something more exciting, whether it's a pair of expensive shoes or that Caribbean vacation you've been dreaming of.
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