DID YOU KNOW?: How to spend that tax refund
The views and opinions expressed in this article are those of the author (credit expert John Ulzheimer) and not necessarily those of VantageScore Solutions, LLC.
Each year millions of people file tax returns, as required by both federal and state tax laws. Some taxpayers have to pay additional taxes when they file their returns due to underpaying throughout the prior year. Other taxpayers receive a refund from their state or the federal government. A tax refund represents the amount of federal and/or state taxes that you overpaid during the prior tax year.
Your tax refund, depending on how much you overpaid the prior year, can sometimes be thousands of dollars. And while the money you’re being refunded is, in fact, your money, the fact that you’re getting it in a large lump sum can often feel like an unexpected bonus. The question you may ask yourself when you get a refund could be, “what should I do with all of this money?”
When you receive a tax refund there are a variety of things you can consider doing with this unexpected lump sum. What you choose to do with the money can pay dividends far in excess of the actual amount you received, but only if you use your refund responsibly.
One of your options is to use your tax refund to pay off existing credit card debt. This can be a smart way to leverage your refund because paying down credit card debt has both financial and credit score benefits.
The average interest rate on a general use credit card, like Visa, MasterCard, Discover, or American Express, is around 16%. Interest rates on retail store credit cards are often above 20%. If you are revolving or “carrying” a balance on one or more credit cards, you are paying interest to service your debt. Because the interest rates on mortgages, student loans and auto loans are normally in the low single digits, the cost to service your credit card debt is likely higher than any of your other debts.
If you reduce or eliminate your credit card balances then you’re going to save money in interest. That’s a mathematical certainty. But, saving money isn’t the only benefit of using your tax refund to pay down your credit card debt. Your credit scores can also benefit by you paying down your credit card debt.
There is a metric in all commonly used credit scoring models called revolving utilization. Revolving utilization is the relationship, expressed as a ratio, between your credit card balances and your credit card limits as they appear on your credit reports. For example, if you have $5,000 in credit card balances and $10,000 of credit limits on your credit reports, then your revolving utilization percentage is 50% because you’re using half of your credit limits. The lower this percentage, the better it is for your credit scores.
To the extent you use your tax refund to pay down your credit card balances, you will likely lower your revolving utilization percentage. Using the same example above, if you pay down that $5,000 balance to $2,500 using your tax refund, you’ll lower your revolving utilization percentage from 50% to 25% and you’ll likely improve your credit scores at the same time.
Additionally, if you use your tax refund to fully pay off some of your credit card balances your scores may benefit even more. Not only will you lower the aforementioned revolving utilization percentage, but you’ll also lower the number of accounts with balances appearing on your credit reports, which is another common and influential credit scoring metric. Point being, there’s really no downside to using your tax refund to paying your credit card debt.
If you maintain the lower balances and the lower number of accounts with balances then your credit score improvement will persist. If, however, you simply incur new debt across the same credit cards then your score improvement will be temporary.
One final accounting note, the reason you got a tax refund, again, is because your employer is withholding too much of your paycheck in order to pay your various taxes. Many accountants would suggest you adjust your withholdings with your employer so they take less money out of your paycheck. The net of this change is going to be larger paychecks throughout the year but a lower, or no, tax refund.