Using Your Tax Refund to Pay Down Debt? Here’s Where to Start

using tax return to pay off debt

If you are used to getting a tax refund around this time of the year, you may have a surprise in store for you. Either your refund will be less than usual, or you won’t get a refund at all. The new tax codes mean less tax taken out of your paychecks, which means you get less of a refund for tax year 2018. Still, if you do get a refund, you’re going to have to decide what to do with the infusion of money. I’d like to suggest you use it to pay down some debt.

Using your tax refund to pay down your debt is a smart decision. Eliminating debt can save money on interest. It can also relieve the stress on your budget throughout the year by reducing your monthly payment obligations. Plus, if you play your cards right, the debts you pay or eliminate with your tax refund might even give your credit scores a boost.

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Installment vs. Revolving Accounts

Not all debts are created equal when it comes to credit scores. If you want to pay down your debts in a way that will potentially benefit your scores, it’s important to understand that debts come in different categories.

There are three types of accounts on your credit reports: installment, revolving and open. With installment debts, you make fixed payments over a fixed amount of time until you’ve paid your obligation in full. Think of a car loan where you make the same payment for 48 months.

Installment debts include:

  • Personal loans
  • Mortgages
  • Student loans
  • Auto loans

Revolving debts can be drawn against over and over. And, your balance, payments and interest fees may fluctuate from month to month. Think of a credit card.

Revolving debts include:

  • Credit cards
  • Lines of credit

Open debts are the least common. And, in this context “open” does not mean the opposite of closed. Open debts are a one-payment-in-full and on-demand type of debt. Think of an American Express charge card. You have to pay the entire balance in full each month.

Open debts include:

  • Charge cards
  • Third-party collections

Why You Should Pay Revolving Debts First

Credit scoring models, like FICO and VantageScore, are designed to pay close attention to your revolving debts – specifically your credit card debts. With all credit score types, your credit card balance-to-limit ratios, or “utilization,” are highly influential and worth a great deal of your credit score points.

If you have outstanding balances on your credit cards, it’s probably among the most expensive debt you carry.

With credit card accounts, incurring large balances will mean an increase in your utilization rate. If your credit reports show that your credit cards have high utilization rates, the impact on your scores will be significant. Since high utilization can damage your credit scores, it’s easy to understand that lowering the same percentage can have the opposite effect. That means using your refund to pay down credit cards is a smart move.

Credit cards are also notorious for having higher interest rates, normally in the high teens. If you have outstanding balances on your credit cards, it’s probably among the most expensive debt you carry. Paying down credit card debt will save you a ton of money in interest fees.

How to Pay Your Credit Cards

If you’ve decided to use your tax refund to tackle your credit card debt, you should go about it in a strategic way. Paying your credit cards off in the correct order may help your credit scores even more.

Credit scoring models consider the utilization on all of your credit card accounts combined, and also on each individual credit card. Each time your credit report shows a lower utilization ratio on an individual credit card account, your score could potentially benefit.

When you’re paying off your credit cards, make a list of your accounts, from the highest balance down to the lowest. Use your tax refund to pay off the account with the smallest balance first. If you have money left over, move up to the next smallest balance on your list. Repeat as many times as you can. By paying off as many credit cards down to $0 as you can, you’ll not only save money on interest, but you’ll also lower the revolving utilization ratio on multiple accounts, which is a great move for your credit scores.