Should You Use Your Tax Refund to Pay Off Debt?

Article Summary:

This article will outline some of the benefits of using your tax return to pay off debt. Additionally, we will help you identify if this could be the right option for you. We will also provide some clever alternative uses for your tax refund that will set you up for financial success.

A tax refund can feel like getting a nice yearly bonus. Last year, the average tax refund was over $2,500. This extra cash will tempt many to treat themselves and make some major purchases. However, it’s important to pause, for a moment, and consider how you can best take advantage of this windfall.

Using your tax refund to pay debt can be a great benefit to your financial well-being. Whether this is right for you depends on your financial goals and situation. We’ll walk through some of the best ways to put your tax refund money to good use. That way, you aren’t just working for your money, but you can have your money work for you.

Should you use your tax refund to reduce credit card debt?

Before you use that tax refund to jump start a down payment on the new car you have been meaning to buy, take time to think. What is your level of credit card debt? If it’s high, you may want to put off that new car purchase a little longer. Yes, it’s enticing to spend the refund cash. But paying down a credit card balance is one the best ways to save money in the long run.

The amount you save in interest payments will vary depending on a couple of factors. One is the size of the card’s outstanding balance. The other is the annual percentage rate (APR) of the card. The average credit card comes with an APR of more than 16%. According to Experian, Americans over the age of 18 had an average of $5,897 in credit card debt in 2020. At a 16% APR, if you made a monthly payment of 3% or $177, then it would take you 45 months to clear the debt.

At the end, you would have spent close to $1,953 in interest alone! That’s nearly 34% of the original balance.

The amount you will pay in interest can negate the amount of an average refund. For this reason, it’s important to consider if it’s really worth it to spend the cash instead of paying down debts.

Advantages of using your tax return to pay off debt

Paying down your debt is not the only clever thing you can do with your tax refund, but it is one of the best options. Using that “free money” to clear some of your outstanding debt has several positives. This debit may include credit card debt, student loans, or perhaps a car loan. Paying down debt will mean not being able to cash in on a major purchase. But your future self will thank you for a variety of reasons.

1. Reduce the overall amount spent on interest

As shown in the example above, not using your tax refund to pay down credit card debt could be costly. A person with 2020’s average amount of credit card debt at 16% APR would spend close to $1,953 on interest.

What if the same person, with the same debt and APR, instead used the return to pay down the credit card balance? How much total interest would this average person have to pay?

Credit card example:

  • Average Refund: $2,500
  • Average Credit Card Balance: $5,897
  • Average interest Rate: 16%
  • Monthly payments: 3% or $177

The average tax refund amount is $2,500. Paying this toward the average balance would reduce that balance from $5,897 to just $3,397. Assuming the same interest rate of 16% and the same monthly payments of $177, it would take you 23 months to pay this off. Remember, this would take you about 45 months if you used your refund for something else. Using the refund to pay down debt reduces the total interest to just $553. Compare this to the nearly $1,953 you’d pay if you didn’t use the tax refund to pay it down.

You calculated that correctly. An average person with average credit card debt at 16% interest would save $1,400. Using your tax refund to pay down credit card balances could save you a lot in the long run. So maybe that new car can wait.

2. Reduce the amount of time you are in debt

Let’s face it, being in debt can be stressful! By using your tax refund to eliminate some debt, you save money and your peace of mind. Just because the refund won’t clear out all your debt doesn’t mean you shouldn’t use it to pay down what you can. Remember what we found in the previous section. As the average person in that example, you could reduce your time in credit card debt by nearly 2 years. By using your tax refund to pay down debt, you get out of debt in about half the time.

3. Increases your credit score

Using your tax refunds to pay off debt can also positively benefit your credit score. A large part of your score depends on the total credit card debt you owe as a percentage of your total credit limit.

Lump-sum payments affect a credit score more quickly than smaller ones. Large payments increase available credit and decrease credit utilization. If these are larger payments there is a sharper decrease in utilization.

Credit utilization

As an example, let’s say you have 2 cards with a limit of $5,000, and your total balances amount to $4,500. So, your total limit is $10,000, which means you are using 45% of that total limit. A $2,500 payment from a refund would decrease your credit utilization all the way to 20%. By keeping that percentage under 30%, you may see an improvement in your score. A credit utilization above 30% will probably hurt your credit score.

The ideal level of credit utilization is, of course, 0% because you won’t have to pay interest. As long as you use your credit card regularly, there is no benefit to carrying a balance from month to month.

Follow the advice of the Consumer Financial Protection Bureau: Keep your credit utilization ratio under 30%. This shows lenders you’re responsible and have available credit. Paying off your entire balance is best and keeps the ratio low. This strengthens your credit scores. Keeping a balance on your credit card could also mean that you spend more on the things you buy because you’re also paying interest.

Carrying a balance is good for your credit? Don’t you believe it! Some “financial experts” claim it is best to carry a balance. They assert that this maximizes credit score improvement. This is a myth. Don’t waste your money paying interest on balances you can afford to pay off.

Other ways to get out of debt fast

Do you have more debt than the refund amount? There are still good ways you can take advantage of the tax return payment. Any payment above the minimum due will be applied to the principal owed. This means you can quickly eat away at large credit balances with your refund.

Debt consolidation loans

If you don’t have enough to pay your debt with the tax refund, consider getting a debt consolidation loan.

Balance transfers

There are also other strategies you may want to consider. These can reduce the time you spend in debt and consolidate your credit accounts. Do you have a high-interest credit cards with balances over the refund amount? A balance transfer could be a great option.

Balance transfers allow you to combine credit card balances into one new account. This new account typically comes with an introductory 0% interest promotion.

Cards offering 0% balance transfer promotions allow you to temporarily prevent interest. This is their main advantage. They also allow you to pay down your balance faster. During the 0% introductory period, payments are not split between interest and principal. So, even if your refund can’t pay your full balance, you know it will be hitting the principal debt. You won’t be squandering part of your refund on interest.

For balance transfers, you have to apply for a new line of credit. So be sure to check your current credit score, credit report, and credit utilization. This will help you get a sense of your current creditworthiness. If it’s good, you may get approved when you apply for the new balance transfer credit card. If it’s not so good, you may need to make improvements before you can get approved.

The promotions for balance transfer credit cards can range from 12–21 months. How much will you need to pay every month to make sure you pay off the whole debt before the promotion expires? Plan for this to be your monthly payment. This will make sure you aren’t simply kicking the can down the road.

Some alternative uses for your tax refund

Maybe you don’t have enough debt to eat up your full refund or you don’t have any debt at all. If so, you are likely looking for responsible and smart ways to use your refund money. You may be interested in some of these other financial strategies.

1. Establish an emergency fund

One of the most common ways people get into debt is by paying for things on credit in an emergency. Shore up your personal finance by creating an emergency fund. This way you know you won’t get into a debt snowball effect when life happens. Savings accounts are particularly important if your income is less predictable. If you are self-employed or own a small business, you know what a less predictable income is like. The last thing you want is for unexpected expenses to drown you in one fell swoop.

2. Set up a Roth IRA

If you don’t have a retirement account, starting one is a great way to use your refund. There are different kinds of retirement accounts, so you may want to consult with an expert. Consulting an expert will help you choose the best type of account for your situation. However, one type of retirement account worth considering is a Roth IRA. Why? It is funded with after-tax income. As with any retirement account, contributed money will grow in the account. But with a Roth, this is tax-free growth. You won’t be charged income tax on it when you pull it out for retirement.

3. Generate new passive income streams

Investing your tax return in generating passive income is one of the best ways to invest in your future. Passive income is an investment that generates income independent of your active participation. This allows you to invest once and reap the benefit indefinitely.

You can earn cash and generate passive income from things like:

Key takeaways

  • Using a tax refund to pay down credit cards or other debts can be very beneficial.
  • Using your tax refund to pay high-interest credit cards will reduce the total interest you pay significantly in most cases.
  • Just because you can’t pay the entire balance doesn’t mean you shouldn’t pay credit cards down.
  • A large payment can improve your credit score by reducing your credit utilization.
  • A financial product, like a balance transfer, can help stall interest charges. This makes sure your tax return is paying toward the principal debt.
  • If you’ve already paid down your debts, consider other uses for your tax refund. One great idea is to build emergency savings. Another is to set up a Roth IRA.
  • Generating passive income is an excellent goal for personal finance. Using your tax return to set up a source of passive income can bring you lasting returns.

Article Sources & Additional Reading
  1. 6 Strategies to Pay Off Credit Card Debt — SuperMoney
  2. Can Debt Collectors Take Your Tax Refund? — SuperMoney
  3. Credit score myths that might be holding you back from improving your credit — CFPB
  4. Deep dive: Credit utilization ratio — SuperMoney
  5. How to Apply for a Credit Card So You’ll Get Approved — SuperMoney
  6. How to Lower Your Credit Utilization Ratio — SuperMoney
  7. How To Negotiate A Debt Settlement – Pros and Cons — SuperMoney
  8. The Carrying a Balance Credit Strategy Myth — MyFico
  9. What is the Ideal Credit Utilization Rate? — SuperMoney