If you received a tax refund this year, you have a great opportunity to set yourself up for financial success in the year ahead. Your first thought may be to put your whole refund toward your credit card balances or personal loans, but it is important to assess your options in order to make the most valuable impact on your financial well-being. Three smart uses of your tax refund include:
1. Setting up an emergency savings account: If you do not have any emergency savings, building this fund before paying off your debt may be your best option. It can seem like a poor financial choice to have cash earning very little interest in a savings account while you are paying 15+% interest on your credit cards, but your emergency fund will likely save you money in the long term.
If you pay down your debt but have no savings, a medical emergency or an unexpected car repair next month can wreak havoc on your finances. You could end up with the same debt you started with, or more. The Financial Coaches at Foresters FinancialTM Everyday Money recommend having 3 to 6 months of income set aside, but $1,000 is a good place to start.
2. Paying down high interest rate debt: Once your emergency fund is established, you can start reducing your debt. Continue to pay the minimum payments on all your debt to avoid penalties, but use your available cash to pay down the highest interest rate debt first.
Even if this is the credit card with the highest balance and you are not able to pay off the entire amount with your refund, you will still be saving the most money by reducing the monthly finance charge and total interest paid over the life of the loan. As an added bonus, paying down a high balance credit card can also significantly improve your credit score.
3. Saving for periodic expenses: While you are paying down your debt, it is important to evaluate how those balances accumulated in the first place. Do you always have a high credit card balance after the holidays? Do you have to pay for standard car maintenance on credit? Do you have a quarterly insurance or tax payment that leaves you with a deficit every few months?
In order to keep your future debt balances low, plan and save for these periodic expenses monthly. Just add up the amounts you spend throughout the year for car maintenance, holidays, and other periodic expenses, divide by 12, and set that amount aside each month. When these expenses come up, you can use your planned savings instead of increasing your credit card balances.
By using your tax refund to both establish savings and pay down high interest rate debt, you will significantly improve your financial well-being for the year ahead.