So you’re expecting a tax refund this year. With inflation driving up the prices of gas, groceries, and just about everything else, that extra cash can’t come soon enough. The hard part is deciding how to spend it. Should you invest the money? Book a trip?
If you really want to do yourself a favor, use your repayment to pay off debt. Here’s why.
YOU SAVE INTEREST
“The debt burden is very high,” says AnnaMarie Mock, a board-certified financial planner at Highland Financial Advisors in Wayne, New Jersey. “Especially if you look at regular consumer debt like credit cards, (the interest rate) could be over 16%.”
Issuers charge higher fees, often well over 20%, depending on the card type or the user’s creditworthiness.
Let’s say you’re trying to pay off $6,000 in credit card debt on a card with a 19% interest rate by paying $200 a month. You pay a total of $2,204 in interest until you pay off the credit card. Here’s how using a tax refund could reduce those costs: If you received a $1,500 refund and put the full amount on the balance and then continued to make the same monthly payment, the total interest you paid would be $1,107 sink. They would also pay off the debt a year early.
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With the US Federal Reserve’s rate hike in March and more rate hikes expected later this year, debt will become even more expensive. Most credit card rates are floating, and issuers are likely to increase them in response to Fed actions. Withdraw more or all of your balance now to avoid overspending interest.
What if you have multiple debts? Accelerating payments to the account with the highest interest rate first, and then moving to the next highest rate (a strategy known as a debt avalanche) is generally the quickest and cheapest way to get out of debt. You can use a debt amortization calculator to estimate how different installments and payment strategies will affect your debt.
YOU CAN BUILD YOUR CREDIT Score
Your credit utilization, or the percentage of your credit limits that you use, is a major factor in your credit score. Using a tax refund to reduce your balance helps reduce your credit utilization, which can benefit your score.
“The higher our credit score, the lower the price of life in general,” says Tina Herndon, manager of financial education and training at Balance, a nonprofit financial education and consulting organization based in Concord, California.
Paying off debt can move you ahead in the long run, she says, and opens the door to cheaper credit. “If you can pay 2.9% interest on a $25,000 car instead of 21% interest, you save hundreds of dollars a month,” says Herndon.
A drastic change in credit won’t happen overnight, and there are other factors that affect your score. But paying off high-yield debt is an important step in the right direction. And having less debt compared to your income can improve your chances of qualifying for a new loan.
Debt can be “a hurdle that people have to overcome mentally before they can potentially move on to the next phase, to start saving for goals,” says Mock.
Make a list of your financial goals. Maybe you want to buy a house or send your child to college. Eliminating debt can get you closer to reaching those milestones.
Maybe your goal is simply to be debt free. Even if your repayment isn’t enough to pay off your debt all at once, the decline in your balance can build the momentum you need to keep working on it.
YOU DON’T HAVE TO GIVE UP FUN
Using your refund to pay down debt doesn’t mean there’s no room for fun shopping. In fact, reducing debt leaves you with more money to do whatever you want. Once you’ve paid your bills, you can use the amount you spent paying for something you enjoy. For example, increase your entertainment budget or set up a holiday fund.
But if you don’t want to wait, treat yourself now. Herndon suggests allocating a certain percentage or dollar amount to a “fun category.” If you get a $2,000 refund, you can set aside 10% or $200 for a spa visit or new headphones.
“It’s all about moderation and making sure you think through the trade-offs of not putting everything in debt,” says Mock.
This article was provided to The Associated Press by personal finance website NerdWallet. Lauren Schwahn is a writer at NerdWallet. Email: [email protected]. Twitter: @lauren_schwang.
NerdWallet: Debt Free https://bit.ly/nerdwallet-how-to-get-out-of-debt
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