Your tax refund came and it’s pretty big, so you're thinking of going on a vacation. Or maybe you’ll make some home improvements? Or just stick it in your checking account to enjoy having extra money for a change…
All worthy thoughts, but let us humbly suggest another, possibly less fun, idea: use your tax refund to pay off debt.
It’s understandable if you're thinking, "pay off debt with tax return or have fun? Gee, I don't know…"
We get it. Using your tax refund to pay off debt sounds about as exciting as using your tax return to pay for a root canal (also a smart idea, if you do, in fact, need one). If you have growing, revolving credit card debt though, isn't it time? If you've been shoveling money toward that card for a while, this could be your ticket toward paying it off and improving your credit score.
Before you go click on a more fun article, seriously, stay with us for a moment. It is worth considering. According to IRS statistics, the average tax refund in 2018 was just shy of $3,000. So, assuming your tax refund is around the average or above it, you’ve recently had or soon will have a large sum of money coming your way.
If you have revolving credit card debt, here is why paying it off, or paying what you can of it off, with a tax refund could be a smart strategy:
You could improve your credit score. If your tax refund can pay off your entire credit card bill, then it's a definite no brainer to go ahead and pay it off. Not only will you get rid of a debt, but you could also improve your credit score in the process. It's really impossible to say how much your credit score will climb. It depends on whether you've had a long history of late fees and missed payments, and how much other debt you have. But pay off your debt, and your credit score should go up.
Even if your tax refund won’t cover the whole debt, you should strongly consider paying off as much of your debt as possible. Say you have a credit card with a $6,000 limit, and you have $4,000 in revolving debt that you haven't been able to pay off. A tax refund of $3,000 wouldn't quite kill it off, but it could help make it much more manageable. And you'd be down to around $1,000 in debt on a $6,000 credit card, so even if you continued to carrying $1,000 in revolving debt on your card, your credit score might actually inch up. Even if you don't immediately see your credit score go up, making inroads on your credit card debt should only help you in the long run.
You could improve your credit utilization. No, it doesn't sound as exciting as using your tax refund to pay for a trip to the Bahamas, especially if you don't know what credit utilization even is, but the point of killing off credit card debt is so you can afford a trip - or lots of trips - to the Bahamas. Or the Poconos. Or wherever you like to get away from it all.
Credit utilization is the amount of credit you have used out of the amount of credit you have been given. So let's say that your credit card gives you $100 worth of credit (that's pretty stingy, but it makes it easier to explain), and out of that $100, you spend $30. That's considered responsible, by most lenders. You've got $70 more to spend if you need it, but meanwhile, you're showing restraint. But if every month, you're given $100 to borrow, and you spend $100, you start to make lenders nervous. Even if… and, yeah, this is the unfair part… you pay back that $100 every month without fail. Lenders like a credit utilization of 30 percent or less. And on that note...
You could also be offered more credit. Obviously, you don't want to get in more trouble and overuse it, but being offered more credit can actually help you manage your money better. Let's say you have a credit card with a $500 credit limit. Spending 30 percent every month means you wouldn't spend more than $150. That might mean one grocery shopping trip, and then you should pay off your credit card before spending more. But if you pay off your credit card debt with your tax refund, and your credit card is happy, maybe suddenly you're given a $1,000 credit limit, and now you can spend $300 a month without having to worry about overworking your credit utilization.
What to do if you have multiple credit cards with debt
What should you do if you have multiple credit cards with debt and your tax refund won’t cover them all? If that's the case, you've got two options. Generally, experts say that both are smart moves, even if only one of them makes mathematical sense.
You can do the snowball method or take the avalanche approach.
The snowball method means that you pay off the card with the smallest amount on it - even if the other credit card has a crazy high interest rate - and then you focus on the other credit card or cards. Obviously, you make the minimum payment on each credit card - you should always do that - but you put your tax refund toward the credit cards that will be easiest to pay off first.
The thinking here is that if you get discouraged by debt easily, you might somewhat give up and stop trying very hard to pay off debt (which just makes things worse in the long run). But if you see that, wow, that $500 credit card debt is now gone, that may help motivate you to then start focusing on other credit cards. So once that $500 is gone, in theory, if you're making the same amount of money every month, you should in the future be able to use the money that used to go to the $500 card to also pay off the next smallest credit card, maybe one with $800 on it. And after the $800 credit card debt is paid off, you can put all the money you were giving your $500 and $800 credit cards to the big $3,000 credit card debt you're working toward paying off.
The avalanche approach focuses on paying off the highest interest card first. Make the minimum payment on all of your credit cards, but put the rest of your money on the credit card with the highest interest. So if that happens to be the card with $800 on it, you focus on that. Or if it's the $3,000 card with the highest interest, go for that. If it happens to be that the $500 card has the highest interest rate, well, you get to do the snowball and avalanche method at once.
You can use our credit card interest calculator to see how much you'll save in interest if you do use your tax refund to pay off credit card debt. You can also see how much you’ll be paying in interest each month if you don’t pay off your debt while you have the chance…
Once you’ve paid off your debts, it’d be wise to make a plan to avoid falling back into debt again in the future. That would include…
Living within your means. We won't lecture you here. But you know the drill - don't overspend.
Stick to a budget. That may mean creating a budget, if you don't already have one.
Don't count on your tax refund to bail you out of every year. After all, you may not get a tax refund every year, and there's an argument that if you're getting huge tax refunds, you're paying the government too much, and you should look into changing what's withheld from your paycheck. Yeah, it's fun to get that windfall of cash, but if you were getting a fatter paycheck, perhaps you wouldn't have wound up overspending on your credit cards?
Start developing good credit card habits. Credit cards can seem evil if you misuse them, and being buried in credit card debt can feel suffocating. However, if you use credit cards responsibly, they can work to your advantage.
If you use a rewards credit card and are earning points or cash back on the purchases you make, and are paying off your bill each month, and therefore not going into debt, you’ll find that you have extra money to spend on more exciting things in life such as vacations, or maybe more responsible things, like putting money towards a retirement or emergency fund.
But if that is a pipe dream at the moment because you still have revolving credit card debt, and lots of it, keep in mind that you could apply for a 0 percent intro APR balance transfer credit card to give yourself some more time to pay down your debt.
Keep in mind though, if you're deep in debt, and you aren’t the most responsible credit card user, this is a strategy that could get you into trouble if you’re not careful. If you use a balance transfer credit card, especially one with a 0 percent APR offer, to transfer all of your debt to a new card, but then you end up using the old credit card (that you transferred money from), and you max that out, or you don’t pay off the debt on your new card (or at least dramatically pay it down) before the 0 percent APR intro period expires, you’ll likely find yourself worse off than you were before.
If used wisely though, balance transfer credit cards can be excellent tools for killing off debt. Some top balance transfer credit cards out there include…
- Citi Simplicity® Card - No Late Fees Ever (This card is not currently available on CardRatings): intro period of 0% APR for 12 months on purchases and 21 months on balance transfers (provided you transfer the money within the first four months of being a cardholder), then 14.74% - 24.74% (Variable).
- Capital One® Quicksilver® Cash Rewards Credit Card (This card is not currently available on CardRatings): intro period of 0% APR on purchases and balance transfers for 15 months, then 15.49% - 25.49% (Variable).
Whatever you do when it comes to your debt, if you have a lot of it, and it's not under control, you'll want to try and tame it soon. You might as well do it in the least painful way possible, and to use your tax refund to pay it off.
And, yes, it's understandable if you're still thinking, "Pay off debt with tax return or have fun? Pay off debt with tax return or have fun? Gee, I don't know…"
But that's the thing. You do know. And as you know, if you don't pay off your debt now, you may pay deeply for it later.