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Updated on Monday, March 9, 2015
Some individuals, including myself, are not thrilled about filing their income taxes each year because they typically end up owing the government. However for millions of Americans, the result of income tax filing will be in their favor.
The IRS reported on February 26 that for the current tax-filing season, the average refund is $3,120 and it had already issued over $125 billion in tax refunds.
Side-stepping the common argument that a tax refund is essentially money that you inadvertently loaned to the government, the more important concern is how best to utilize this surplus of cash.
While splurging on a new spring wardrobe or taking an all-inclusive vacation sounds fun, if you have debt, especially consumer debt, then it’s a good idea to put the brakes on the carefree spending options.
Instead, invest in your financial health and pay down debt by using your tax refund in the following ways.
Crush Your Credit Card Balance
You likely know how much you owe, but do you know how much interest you’re being charged?
If you don’t know your credit card’s interest rate, then take a look at your most recent statement. The average interest rate is near 15% and it’s even higher for retailer credit cards such as Macy’s or Home Depot. By paying off high interest debt like credit cards, you are getting an immediate return on savings of the interest expense.
It’s frustrating to pay off a $5K credit card balance when making only the monthly minimum payments but if you were to reduce the balance with a $2500 refund in one fell swoop, you will have shaved over a year off your debt repayment schedule.
Even better, you could utilize a balance transfer to drop your interest rate to 0% and then your entire refund could go towards paying off the principal debt. You could dig out of debt months or years faster and save hundreds to thousands of dollars.
Get a Head Start on Your Student Loans
You may not have any credit card debt but you do have student loans piling up alongside with your stress levels.
Although student loan interest rates are not nearly as high as those of credit cards, the current rate for the 2014-2015 school year for the undergraduate Stafford loan is 4.66%.
At the latter rate, it would cost you $1,264.55 in interest for a $5,000 loan over a ten year repayment period. Apply your mathematical sense to lessen the amount of interest and pay your student loan sooner thanks to a lump sum payment like a tax refund.
Deal With Debt in Collections
Whether it’s due to poor financial decisions or a life crisis such as a job loss or medical event, you may have a past due account that has been sold by the creditor to a collections agency.
If you can truly not afford to repay the debt in full, try negotiating a settlement amount with the collections’ company that can be covered in part or whole with the proceeds of your refund.
Once you have a signed agreement in place, you will have avoided the possibility of a lawsuit and begun the process of repairing your credit history, even though the settlement could appear on your credit report for seven years. Also note that the unpaid amount not included in the settlement will be reported to the IRS and federal income tax may be owed as a result.
Honor Personal Debts
I didn’t like owing creditors when I was working to pay off my consumer debt but owing a parent or friend money would be a debt I’d want to pay off as fast as humanly possible.
These types of personal loans typically tend to attach little to no interest rates but they can be fraught with emotional strings. Circumstances can change wherein the lender, aka the bank of Mom & Dad, were initially in the position to lend you the cash but are now in need of the funds. This may cause a strain on the relationship if the debt remains unpaid.
Being able to pay down a personal loan in part or in full with your tax refund can provide a source of fiscal and psychological relief not only for yourself but for the person you care for that funded the loan.
Save a Little
A tax refund can also be used to pay down debt and create an emergency savings fund. Emergency funds can prevent you from sinking deeper into debt in the future when something goes wrong with the car or an unexpected medical expense pops up. Putting $500 or $1,000 away in a savings account provides a helpful debt buffer.
Using your tax refund to pay down debt may not elicit the same level of excitement as treating yourself to some wants, yet you are wisely positioning yourself to reap financial benefits in the short and long term.