After diligently filing your income taxes, you’re greeted by a pleasant surprise: you get a refund. And where others may see a surprise windfall as an excuse to go out on the town or pick up that must-have gadget they’ve been eyeing, you make the smart decision to be responsible with your unexpected bonus, choosing instead to put it toward your personal financial stability.
First off, good choice! But now it comes time to make another important decision: do you save that extra money, perhaps for retirement, or use it to pay down debt?
All in all, this decision has no one right answer, as the best thing to do with your tax refund will depend strongly on your individual financial situation. To help narrow down the smartest way to use your refund, ask yourself the following three questions to see where your finances stand.
Are You Behind on Any Debts?
The very first question to ask yourself is whether you are behind on any of your bills or debts, which includes everything from utility and housing payments to credit card and loan payments. If the answer to this question is, “Yes,” then you can stop right here. Your tax refund is best used to catch up on those debts to prevent them from damaging your credit or, worse, becoming charge-offs.
If you have any of your tax refund left once you’ve brought all of your delinquent accounts back into good standing, you may want to look at ways to avoid falling behind in the future. For example, credit card balance transfers can be a good way to lower your interest rate (and, thus, your payments), but there are only a few no balance transfer fee credit cards. The money you spend paying a balance transfer fee can often be recouped by the interest rate savings.
Do You Have Any High-Interest Debts?
If you don’t have any delinquent bills or debts, or you have a portion of your refund leftover after catching back up, you’ll next want to look at any high-interest debts that you currently owe. Start by listing all your debts by interest rate to see where you stand. Any debts with double-digit interest rates should be your first priority, including short-term loans or high-interest credit cards. The debts with the highest interest rates are costing you the most money, so they’ve got to go.
What generally won’t be included on the high-priority debt list are longer-term installment loans, like auto loans and mortgages, that typically have much lower interest rates. Even bad-credit mortgage loans tend to have single-digit interest rates, making them typically the least expensive type of debt to carry.
Once you’ve identified your most expensive debt, focus your tax refund on paying it down. If your refund happens to be enough to pay off that debt entirely, put the remainder toward your next-highest-interest debt (and so on).
Instead of paying off your highest-interest debt first, it can be tempting to instead focus on your smallest debt so that you can enjoy the satisfaction of crossing it off your list entirely. While this method (often called the “snowball method”) can be an effective debt repayment strategy overall — studies say snowballing your debt can have good long-term success — focusing on the highest-interest debt (also called the “avalanche method”) is the more cost-effective plan.
Do You Have an Emergency Fund?
The final question to ask yourself before dumping your tax refund into your retirement savings is whether you have a healthy emergency fund set aside to deal with any unexpected financial events. Most experts suggest having at least three to six months’ worth of emergency savings to cover your necessities in the case of job loss or injury, but even a few hundred dollars to pay for a sudden car or home repair can save you from taking on unnecessary debt in the future.
Once you’ve paid down your outstanding and high-interest debts and built up a solid emergency fund, you’re now ready to focus what is left of your tax refund on more general savings. This may mean a retirement account, such as a 401(k) or IRA, or if your retirement accounts are already in great shape, a personal investment account.
Other than your emergency fund and whatever monies you use for bills, avoid keeping excessive amounts of money in a standard savings account. These accounts tend to have interest rates of 1% or less (more often less), meaning a typical savings account won’t even keep up with the rise in inflation, let alone help you build wealth. Focus instead on investments that will net at least a higher rate of return than the current rate of inflation to avoid losing out on potential income.
If you’re concerned about your credit this tax season, learn how you can start repairing yours. Contact us today to get started.