Every year, millions of Americans file tax returns, as required by both federal and state tax laws. For some taxpayers, filing means discovering they owe additional taxes due to underpaying throughout the prior year. For many others, however, tax season brings a much more pleasant surprise: a refund. A tax refund represents money paid in excess of the taxpayer’s actual tax liability from the previous year. In other words, the government withheld more than necessary from an individual’s paycheck and is now returning that owed money.
Depending on an individual’s income and tax withholdings, refunds may reach thousands of dollars, which can feel like a surprise bonus. Even though the refund is technically your own money being returned, the psychological effect of receiving it all at once often makes people see it differently from their normal paycheck.
With all this money, it may be tempting to splurge on a vacation or a shopping spree. While it’s good to treat yourself from time to time, it’s worth asking yourself: What is the smartest way to use this money? If used wisely, a tax refund could be a great opportunity to improve your financial health, a benefit that lasts long after tax season has ended.
The Cost of Credit Card Debt
Using your tax refund to pay off existing credit card debt is one of the most effective ways to leverage it, since it offers both financial and credit score benefits.
Credit cards are convenient financial tools, but they can also be very expensive if balances are carried from month to month. The average interest rate on a typical credit card, like Visa, MasterCard, Discover, or American Express, exceeds 20% and is typically much higher than other forms of debt.
When you carry a balance on a credit card, interest is charged on that debt each month. Over time, those interest charges may accumulate dramatically. Even a balance of a few thousand dollars can grow into hundreds or thousands in interest if not repaid quickly. The longer a balance remains unpaid, the more expensive it becomes.
Other types of debt, like mortgage interest rates, student loan rates, and auto loan rates, are often significantly lower, typically in the low single digits. This means the cost of servicing credit card debt usually exceeds that of any other debt you may have. Using your tax refund can help you avoid future interest charges and free up money in your monthly budget.
Paying down credit card balances can also significantly improve credit scores. Aside from missed payments on your obligations, your outstanding debt, and specifically your credit card debt, is the second-most influential factor in your credit scores. How much open credit you use, how many accounts have current balances, and how close those balances are to reaching their limit will all weigh into your credit score. Using your tax refund to pay down your credit card balance can significantly improve your credit score.
TIP: If you want to learn more about the different factors that influence your credit score, check out The Complete Guide to Your VantageScore Credit Score.
Understanding Revolving Utilization
One of the most important credit-scoring metrics for credit cards is revolving utilization. This metric measures the relationship between your credit card balances, and your credit card limits as they appear on your credit reports, expressed as a ratio.
For example, if you have $5,000 in credit card balances and $10,000 of credit limits on your credit reports, then your revolving utilization percentage is 50% because you’re using half of your credit limits. The lower this percentage, the better it is for your credit scores. High utilization implies that you may be relying heavily on credit.
If you use your tax refund to reduce those balances, you can quickly improve this ratio because lowering balances is the key to keeping your credit scores strong. Using the same example above, if you pay down that $5,000 balance to $2,500 using your tax refund, you’ll lower your revolving utilization percentage from 50% to 25%, and you’ll likely improve your credit score at the same time.
While paying down credit card balances can improve your credit scores, you should maintain those improvements over time. If you use your tax refund to reduce balances but then quickly accumulate new debt on the same cards, the benefits to your credit score may be temporary. To get the most out of your refund, try to combine paying off debt with better spending habits, like being more careful with credit cards or trying to pay off your balance in full each month.
TIP: For more information on how credit utilization affects credit scores, check out Credit Utilization Ratio: The Lesser Known Key to Your Credit Health.
The Debt-to-Limit Ratio Explained
Closely related to revolving utilization is the debt-to-limit ratio, another important metric used by credit scoring models. The debt-to-limit ratio is the relationship between the outstanding balance and the credit limit. It’s calculated by dividing the balance by the limit, then multiplying the result by 100. For example, if you have a $5,000 balance on a card with a $10,000 limit, then your debt-to-limit ratio is 50 percent. While 50% isn’t terrible, it’s not ideal either. Reducing that ratio to 30% or even lower can significantly benefit your credit scores.
Credit scoring models evaluate this ratio by analyzing the ratio for each individual credit card. A card that is close to its credit limit can harm your score even if your other cards have low balances. They also examine the overall ratio across all your cards combined to get the bigger picture of your total credit usage.
If you apply your tax refund to a high-balance card near its limit, you could quickly improve both the individual ratio for that card and your overall utilization. For example, reducing a balance from $5,000 to $3,000 lowers the ratio from 50% to 30%, an improvement that credit scoring models typically view favorably.
Adjusting Your Withholdings
As a reminder, a tax refund occurs due to your employer withholding a large portion of your paycheck in order to pay your taxes. While receiving a refund can feel rewarding, many accountants may argue that it’s essentially an interest-free loan to the government. Instead of having access to the money yourself, you’re letting the government hold it throughout the year.
If you prefer having more money available in your monthly budget, you might consider adjusting your tax withholdings with your employer. Doing so could increase your take-home pay each month while reducing or eliminating your annual tax refund. For some people, however, receiving a large lump sum can make it easier to pay down debt or accomplish other financial goals.
Overall, the best approach depends on your preferences. Whether your refund is a few hundred dollars or several thousand, consider that once-a-year refund an opportunity to improve your financial future rather than an excuse to overspend.
