So you expect a tax refund this year. With inflation driving up the price of gas, food, and just about everything else, that extra money can’t come soon enough. The hardest 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 refund to pay off your debts. Here’s why.
YOU SAVE ON INTEREST
“The cost of debt is very high,” says AnnaMarie Mock, Certified Financial Planner at Highland Financial Advisors in Wayne, NJ “Especially if you’re considering regular consumer debt, like credit cards, (the interest rate) could be north of 16%.
Issuers charge higher rates, often well over 20%, depending on the type of card or the user’s credit score.
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 will pay $2,204 in total interest when the credit card is paid off. Here’s how using a tax refund could reduce that cost: If you receive a refund of $1,500 and apply the full amount to the balance and then continue to make the same monthly payment, the total interest you pay would drop to $1,107. You would also wipe out the debt a year earlier.
With the Fed funds interest rate hike from the Federal Reserve in March, as well as further hikes expected later this year, debt is becoming even more expensive. Most credit card rates are variable and issuers will likely increase them in response to Fed actions. Pay off some or all of your balance now to avoid overspending on interest.
What if you have multiple debts? Accelerating payments to the account with the highest interest rate first, then moving to the next highest (a strategy known as debt avalanche), is usually the quickest and least expensive way. expensive to get out of debt. You can use a debt repayment calculator to estimate how different rates and payment strategies will affect the amount you owe.
YOU CAN BUILD YOUR CREDIT SCORE
Your credit utilization, or the percentage of your credit limits that you use, is an important factor in your credit score. Using a tax refund to reduce your balance helps reduce your credit use, which can benefit your score.
“The higher our credit score, the lower the price of living in general,” says Tina Herndon, head of financial education and training at Libra, a nonprofit education and counseling organization. financiers based in Concord, California.
Paying off debt can get you ahead in the long run, she says, opening the door to more affordable loans. “If you can pay 2.9% interest on a $25,000 car instead of 21% interest, it’ll save you hundreds of dollars a month,” Herndon says.
A drastic change in credit won’t happen overnight, and there are other factors that shape your score. But paying off the high-rate debt is an important step in the right direction. And having less debt relative to your income can improve your chances of getting new credit.
Debt can be “a hurdle that people have to mentally overcome before they can potentially move on to the next phase, to start saving for goals,” Mock says.
Make a list of your financial goals. Maybe you want to buy a house or send your child to college. Eliminating debt can bring you closer to reaching these milestones.
Maybe your goal is simply to be debt free. Even if your repayment isn’t enough to wipe out your debt all at once, seeing your balance drop can create the momentum you need to keep reducing it.
YOU DON’T HAVE TO SACRIFICE PLEASURE
Using your refund to pay off debt doesn’t mean there’s no room for fun shopping. In fact, by reducing debt, you will have more funds available to do what you want. Once you’ve paid your bills, you can take the amount you were spending on payments and put it towards something that brings you joy. Increase your entertainment budget or create a vacation fund, for example.
But if you don’t want to wait, go ahead and treat yourself now. Herndon suggests allocating a certain percentage or dollar amount to a “fun category”. If you receive a $2,000 refund, you can set aside 10%, or $200, for a spa visit or new headphones.
“It’s about moderation and making sure you think about the trade-offs of not investing everything in debt,” Mock says.
This article was provided to The Associated Press by personal finance website NerdWallet. Schwahn is a writer at NerdWallet and can be reached at [email protected] Twitter: @lauren_schwahn.