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Why Your Tax Refund Is Ideal for Paying Credit Card Debt

Feb. 24, 2017
Credit Card Basics, Credit Cards
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If you’ve ever promised to pay off your credit card debt “when you have more money,” now’s your chance. The Internal Revenue Service estimates that 70% of taxpayers will get refunds this year. Last year, the average refund was $2,860, according to the IRS.

If you’re in the red, using the bulk of your tax refund to pay down your high-interest credit card debt can give you some fast financial relief, with almost no effort on your part. Maybe that’s why the idea is so popular: In a 2016 National Retail Federation survey, about 39% of American adults said they planned to use their refund to pay down debt.

To be sure, simply paying off credit card debt doesn’t address the underlying causes of that debt, so it might not keep you from winding up in the same position down the road. It also isn’t necessarily everyone’s No. 1 priority. You may want to spend your refund elsewhere if:

  • You don’t have an emergency fund. Sock away at least $500 in your bank account before tackling your credit card debt.
  • Your debt is out of control. If your debt is more than half your annual income and you see no way to pay it off within five years, bankruptcy might be your best option.
  • Your credit card debt is interest-free. If you have debt on a 0% APR credit card, you’ll save more money by tackling higher-interest debts first. Just be sure to pay down your balance before the 0% period ends.

But if your credit card debt is gnawing away at your monthly budget, here’s why tackling it now is your best call.

You’ll save money on interest

When you have a mountain of credit card debt, interest charges slowly drain you of cash.

Credit card issuers charged an average annual percentage rate of 13.61% on accounts that incurred interest last quarter, according to the Federal Reserve. At that rate, if you carried an average balance of $5,000 for a full year, you’d pay almost $700 in interest. And since credit cards are open-ended lines of credit, you can carry that debt virtually forever, as long as you keep making the minimum payments. You don’t want to let that happen.

The easiest way to lower interest costs is to transfer your credit card debt to a 0% APR credit card, and doing so is a smart idea. But these cards often aren’t available when you need them most. If your credit is so-so and your debt-to-income ratio is high, you might not be able to qualify for one.

If getting a 0% APR card isn’t an option, paying down your debt more quickly might be your best bet for saving on interest. Your tax refund can help you do just that.

It could boost your credit

If your credit is a little “meh” lately, it might be due in part to all the credit card debt you’re carrying.

“Amounts owed” — that is, how high your balances are — accounts for 30% of your FICO score and is a “highly influential” factor in your VantageScore. Credit utilization ratio, or the percentage of available credit you’re using, is a major factor in amounts owed. As a rule of thumb, it’s a good idea to keep your balances below 30% of your credit limit at all times. The lower you can keep your balances, the better.

Applying your refund to your credit card debt can help you reduce both your overall debt and your credit utilization ratio quickly. This can help your credit score, making it easier to qualify for more affordable credit products and even potentially helping you save on car insurance.

» MORE: Check your credit score for free

It’s a painless path to a fresh start

Sometimes, the most difficult thing about paying down debt is the “paying” part.

Because of a psychological effect called loss aversion, losses can loom larger in our minds than gains. That’s why it’s painful to see money leave your bank account — even if you know those extra payments are helping you save on interest.

When you pay down your credit card debt with your tax refund check, though, you get to pay down that credit card debt with “found money,” instead dipping into your savings. That makes it a little less painful.

It also gives you a chance to build new credit card habits that can make paying a little less daunting. You might decide to make payments on your credit card balance once a week, for example, so it’s more manageable. Or you could start a new budget to keep your spending down. Wiping out your credit card debt with a tax refund may be a quick fix, but changing these fundamental spending habits can help you save for years to come.

Claire Tsosie is a staff writer at NerdWallet, a personal finance website. Email: [email protected]. Twitter: @ideclaire7.