Using Your Tax Refund To Pay Off Debt? Here’s the One You Should Pay First
It’s tax refund season, and many Americans are making plans for the money they’ll be getting back soon.
In fact, a recent survey by GOBankingRates showed that 65% of Americans expect a tax refund this year. And 15% of respondents specifically said they want to pay off debt with their tax refund.
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But before you take a chunk of your refund to pay down your car loan or credit cards, it’s a good idea to take inventory of your overall financial situation first. GOBankingRates interviewed Philip Wentworth, Jr., tax expert and owner of Rockerbox Tax Solutions, to help figure out how best to approach using your tax refund for debt payoff — including what to focus on first.
Before Paying Off Debt…
Before you take your refund and pay off your debt, it’s important to take a few actions to help set yourself up for debt payoff success.
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Stop Using Consumer Debt
Before you start paying off your debt, you need to make a hard commitment to stop using consumer debt for purchases. This includes no borrowing for cars, furniture, electronics or other major purchases.
You should also commit to stop using credit cards for the time being. This will ensure that you don’t continue digging yourself into further debt while you’re trying to pay it off. You can’t get yourself on solid ground if you don’t put down the shovel that’s digging your financial hole in the first place.
And while it may take some time to transition off of using credit cards and loans for purchases, it’s the most important thing you can do to ensure that debt payoff isn’t a one-time thing — but a lifestyle change.
Know Your Numbers
Before you can choose which debt to pay off, you need to know your personal numbers inside and out. This will give you more clarity on where you have the most financial need and how debt payoff can play a role in your finances. Here are a few numbers you need to know:
Debt totals: You’ll need to total up each debt you have and list them out. This will give you a full picture of your overall debt balances.
Debt interest rates: Next to each debt, you’ll need to list the interest rate. This can help inform your debt payoff strategy.
Debt minimum payments: Next to each debt, list the minimum payment. This will help you understand the impact on your monthly budget.
Your monthly budget: Speaking of your budget — you need to put together a budget before moving forward, so you know how much you are spending and saving, if anything, each month. This will help inform your debt payoff plan.
Once you have a clear picture of your numbers, you can put together a plan for your tax refund money that is in your best financial interest.
Save One Month of Expenses
While paying off debt can bring some much-needed relief to your financial life, it’s important to have a solid financial footing first. This means having a small emergency fund set aside to help pay for unexpected expenses and to help avoid going further into debt if an emergency comes up.
It’s important to set aside at least one month of expenses to cover emergencies, such as car trouble, home repairs or a lost job. While this may not be quite enough to cover very large emergencies, it’s enough to handle day-to-day unexpected expenses without having to go further into debt.
Debt Avalanche vs. Debt Snowball
Once you have your financial house in order, it’s time to pick a debt payoff strategy. There are two main ways to approach paying off your debt: the debt avalanche and the debt snowball. Both have their advantages — here’s how they compare:
Debt Avalanche
The debt avalanche focuses on paying off your high-interest debts first. This means you will list all of your debts from highest interest rate to lowest, and focus on the one with the highest rate while paying the minimum payment only on the others.
“Aiming for high-interest debt first maximizes your savings on interest payments,” said Wentworth, Jr. “This strategy can significantly reduce the amount you end up paying in the long run, especially if you’re dealing with credit card debt or high-interest loans.”
The downside is that it may take a while to get rid of high-interest debt if it has a higher balance than other, lower-interest debts.
Debt Snowball
The debt snowball is similar to the debt avalanche in that you only focus on one debt at a time — but with the snowball, you’ll list your debts in order from the smallest balance to the largest. This means you’ll knock out your first debt quicker than with the avalanche, though you may end up paying more interest if your higher-balance debts have higher interest rates.
“This approach can boost your motivation by providing a sense of accomplishment early in the debt elimination process,” said Wentworth, Jr. “It’s not just about the numbers; psychology plays a big role in maintaining momentum towards debt freedom.”
People are intrinsically motivated to stick with a new habit if they see a quick win — and the debt snowball may offer a faster win than other methods by focusing on smaller-balance debts.
The Key to Any Debt Payoff Strategy Is…
Whichever debt payoff plan you choose — the truth is that the magic lies in your focus. Both methods have you focus on paying off one debt at a time, helping you avoid burnout and stacking your wins by taking the minimum payments from paid-off debts and putting them toward the next debt.
In most cases, mathematically, there is very little difference between the debt snowball and debt avalanche methods. And you can negotiate interest rates down, so the difference is really negligible. But if you can pay off one debt and free up some cash flow in your budget, that will help you pay off the remaining debts subsequently quicker — which helps you keep the motivation to keep going.
Pay Off Debt or Invest?
While debt payoff may be at the top of your priority list, it’s not always the best option for extra money you come across — like your tax refund. In some cases, investing may have a better return on investment and better growth potential than paying off your debt.
“Juxtapose debt payoff with potential investment opportunities, especially if you own a business or can invest in one,” said Wentworth, Jr. “Sometimes, investing a portion of your refund can yield a return greater than the interest saved by paying off debt. It’s a calculated risk but one that needs consideration.”
Overall, it’s important to explore your investment opportunities before throwing all of your tax refund at your debt.
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This article originally appeared on GOBankingRates.com: Using Your Tax Refund To Pay Off Debt? Here’s the One You Should Pay First
