If high credit utilization is weighing down your credit score, a tax windfall can help you pay down your card balance. But that might not be the best use of the money.
It’s that time of year when some consumers dream of what they can buy with their tax refund (or, in the case of this year, their stimulus check). Meanwhile, more practical consumers may be thinking about what they can do with that money to improve their financial situation.
While it’s easy to understand the desire to use these checks as fun money, it might be better to lean toward practicality this year. Lest we forget, we are in the midst of an ongoing pandemic.
One way you can use windfall money to improve your finances is to boost your credit score by paying down debt. Here’s how:
How credit utilization affects your score
Credit card debt isn’t a direct factor that FICO considers when calculating your credit score. But it can still impact your score because FICO does calculate how much of your credit you use. More specifically, credit utilization accounts for 30% of your overall credit score.
If you regularly carry a high credit card balance, the amount of your credit limit that you use each month is probably high as well. A good rule of thumb is to keep your utilization below 25% or 30%, but that’s not a hard-and-fast rule. The less you use, the stronger your score will be.
Using your tax refund to reduce your credit utilization ratio
Let’s say you have a rewards credit card with a $3,000 limit that has a $2,500 balance. That card would have a utilization of 83% – that’s way too high! If you’re aiming for a utilization closer to 25% to 30%, you’d want to have a balance between $750 and $900. If you had a $1,600 tax refund, putting all of it toward your debt would get you to an ideal credit utilization range, which would in turn help your score.
But life rarely works out this neatly, and this strategy might not be the best decision for you. For one thing, you might not get enough of a tax refund to bring your overall credit balance below 25% – especially if you have high debt. Plus, what if you can’t keep it at that level long term? It won’t do you a lot of good if your balances creep back up a few months later.
If that’s the case, you might be able to put your tax refund to better use elsewhere.
See related: The ultimate guide to doing your taxes
If you’re unemployed
If your employment is in jeopardy or you have been laid off this year, using this money to pay down your debt might not actually be the best use of these funds. If this is your situation, I’d suggest taking some of your stimulus check or tax refund and putting it aside to make minimum payments on your credit cards and other debt while you look for new employment. Allocate the rest of the money for current living expenses like food, housing or utilities.
Keeping some of your money back to cover your debt will allow you to leverage credit lines to help you get through this crisis by making minimum payments. Then, once you’re working again, you can take advantage of repayment programs to work down your balances.
Look into a debt management plan offered by a nonprofit credit counseling agency or a hardship program directly with your creditors. With both of these options, you’ll be able to keep your credit report looking good, though some credit card hardship programs lower your credit limit, which could have a small impact on your report.
If you truly don’t need the money you’ll get from a stimulus package or tax refund, you might consider helping your fellow Americans who are not in such a position. So before you use this as fun money, consider looking into local food banks, animal shelters or programs that support people experiencing homelessness. You’ll be able to help others, and if you pick an eligible nonprofit organization, you’ll be able to get a break on your 2021 taxes.
Remember to keep track of your score!