Should we use our tax refund to pay down our debt?
Great question. This is a good time of year to take a closer look at finances. The holidays are a distant memory and taxes are hopefully out of the way. By now many have or will shortly receive any tax refund due to them. Before you decide how to use your tax return, I would ask some questions to help determine the best plan of action.
Are you using a budget? If not, it’s likely that you are spending too much. A budget may prevent this pitfall. Money is a tool and like any tool it needs to be used properly. If you are careless with a hammer, you just might smash your thumb. The misuse of money can cause pain of a different nature but, with longer term ramifications. Don’t let this be you.
Your budget will tell you how much money is coming in and how much is going out. You will have a deficit or a surplus. If you do not have a surplus, then you must adjust. Spend less or earn more but, you must fix it.
How much money is in your emergency savings account? I ask this because you will want to have at least minimal emergency savings started before you start reducing your debt. For someone just starting to save for emergencies, the first goal is $1,000, then one month of living expenses and continue building that up to six months. If you don’t have this cushion you will add consumer debt when the first unexpected expense occurs. Remember to expect the unexpected.
What kind of debt do you have? I won’t say that there is good or bad debt but, we can all agree that some debt is more detrimental to your finances. That which has higher interest rate charges and those purchases of assets which depreciate quickly is best to avoid. Credit cards, auto loans and debt consolidation loans are considered consumer debt, and this is where many people get into trouble. The interest which you pay on your consumer debt is not deductible from your taxable income. According to Bankrate.com the average interest charged for credit cards is 16.38%. It would be best to pay down this type of debt with that tax return.
One can also incur debt for medical expenses which may be unavoidable. Perhaps you incurred a tax liability due in part to a lack of planning or some other unforeseen financial event. Due to the new tax law many tax payers did not withhold enough during the year, state and local taxes in particular (SALT), and have been caught off guard with underpaid taxes due. The mortgage interest you pay may not be the tax shelter it was prior to change in tax deductions. Therefore, careful consideration should be given regarding tax planning, or paying down mortgage debt, before making that decision.
Once you have addressed your budget and your emergency savings situation and the type of debt which you have then, you can make an educated decision whether you should use your tax refund to pay down debt, open a new investment account, fund your retirement account or go on a relaxing vacation. I believe the interest which you are paying for consumer debt is worse for you, than the potential growth earned in an investment account might be beneficial to you. To clarify, pay down consumer debt before investing.
There are different ways to deal with your debt. Some might switch credit card balances to a new card offering lower or zero introductory rates. Seems reasonable. Here is where this plan goes bad. Even though you are getting a better rate and possibly slowing the growth of your credit card debt, the new card will undoubtedly have a one-time fee of (X) percent. The same is true for consumer debt consolidation loans. With either of these strategies, you should chop up your credit cards because behavior is an issue. Otherwise you will end up with an additional debt to pay down and higher debt service making your cash flow even tighter.
Refinancing your mortgage and withdrawing equity to consolidate your debt into easier to handle debt service is a possible option. This will indeed reduce the monthly payment for your debt service but, it hasn’t reduced your debt. In fact, it may stretch out the length of time it takes to pay down that debt. Again, behavior is an issue.
One approach is to pay off the debt with the highest interest rate first. You pay whatever extra you can find to pay off this debt first. Then pay down the debt with the next highest interest rate charged. This is fine if you can handle your current debt service and you are disciplined. This may save you quite a bit in interest charges over the life of the debt.
Another strategy is the debt snowball. The Dave Ramsey fans out there will recognize this. Instead of focusing on the debt balance with the highest rate, focus on paying off the debt with the smallest balance first. Once that debt is gone add that payment amount to the next smallest balance. This strategy gives you victories fast and do not underestimate the psychological power of winning, even small wins.
Resources for credit counseling services: Consumer Credit Counseling Services credit.org/cccs; National Foundation for Credit Counseling nfcc.org; Christian Debt Counselors christiandebtcounselors.net; Money Management International moneymanagement.org.
Resources for budget tools: everydollar.com, mint.com, nerdwallet.com, gnucash.org, levelmoney.com is like an envelope system on your phone. Check with your bank and of course your financial advisor. All our clients get access to an easy to use online budgeting tool and some use it! We even have envelope systems for those who prefer old school and don’t forget good ol’fashioned pen and paper.
As I stated a few times above, behavior matters. Why? Because none of the above will work if you do not change your behavior. We all need to live within our means and make changes if we are not. If only the government would do the same. Until we talk again, be well.
Registered Representative offering securities and advisory services through Independent Financial Group, LLC (IFG), a registered broker-dealer and investment advisor. Member FINRA/SIPC. Dedicated Financial & Insurance Services and IFG are unaffiliated entities.