The average tax refund is approximately $2,323 per filing (as of March 16, 2023). This is a significant chunk of change that can be used in helpful ways to make the rest of your financial year easier. You may be wondering how to best use your tax refund and if paying off debt is a good idea. The short answer: it probably is! Below are some pros of using your tax refund to pay off debt–including some cons.
Less Debt Now Means Less Interest Paid Later
With credit card, auto loan, and mortgage interest rates where they are, a good chunk of your payment each month is going to interest rather than principal. If you make extra payments, they go towards the principal (the total amount that you owe). This reduces the interest you have to pay on the remaining principal.
Less Debt = Better Credit Score
Paying down credit card debt in particular can positively affect your credit score. An important factor in your credit score is something called a credit utilization ratio. A credit utilization ratio is the relationship between how much credit you have available to you versus how much credit you’re using. Having less credit used on your credit cards means a lower ratio, which means a higher score!
Progress and Motivation
Seeing those balances go down can be very motivating. With the load of debt lightened, you may have some extra wind in your sails to continue budgeting. This can help you stay on track with your financial goals.
No Rainy Day Fund
If you put your entire refund towards paying off debt, then you won’t have any saved for emergencies. This means if an unexpected expense does arise, you will need to use credit to pay for it. This will put you back in the position of being indebted. Thus, you will want to save some of your tax refund for a rainy day so you can use it in case of an emergency.
Big Purchases Later Could Mean More Interest
If you’re planning on making a big purchase this year on credit, it may be a good idea to use your tax refund to pay for it in cash to avoid racking up debt. The average interest rate on credit cards is currently 20-25%. This means you could be paying that much extra on your purchase.
If you spend your entire tax refund on paying off debt or saving, you may feel there is nothing left over for you. This can lead to feelings of deprivation or resentment. Consider setting aside a small amount of “fun money” to treat yourself.
Overall, it is good to strike a balance between debt management and having enough saved for emergencies and major purchases. It may be tempting to get those balances down to zero, but you need to make sure you don’t need to dip into credit again right away.