Use tax refund to pay down a credit card

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Dear Debt Adviser,
I am going to be receiving a $2,700 tax refund. I want to use this money to pay down debt. I have about $1,700 in credit card debt which is really hurting my credit because it is at the max. I am also upside down on a car loan. I owe $5,000 on my car and want to get it paid off so I can get into a new one. My current vehicle is falling apart and becoming expensive to fix. Do I put the $2,700 toward my car loan and bring that total down which will pay it off quicker? Or, do I pay off the credit cards and take the leftover and put it toward the car loan? My car loan has a very high interest rate of 19.75 percent. I want to do what will make the most sense. Thank you!— Elizabeth

Dear Elizabeth,
Your letter is timed perfectly for me to give you and my other readers some advice on how to use your tax refund wisely. Your choice of paying down existing debt is a great way to make that tax refund money work for you. We’ll get to some other smart moves for tax refunds later in the column.

As far as your question of which debt to pay down, your credit card or your car loan, I’d like you to consider a couple of things:

  1. Car dealerships are begging for customers right now and as a result, are willing to make great deals to sell a car.

On the other hand, credit card issuers are not begging for anything but government, taxpayer, funds. So they have less of an interest in playing “Let’s Make A Deal” right now. I recommend you take your car with the upside down loan to the dealership of your choice and request that they give you what you owe on your car as trade-in value. This may result in your carrying a larger loan on the new and more reliable car, but it may be cheaper with the great interest rate and incentive deals available. If this works out, then you could use your tax refund to pay off your credit card and use the remainder of the money as a down payment on your new vehicle, or for the other possibilities at the end of my column.

  1. Don’t get carried away, or perhaps I should say driven away in this instance, into a loan you can’t afford. Only purchase a new car if you can realistically afford the monthly payment. In addition, make the deal on your old car trade-in before talking terms on your new car purchase.

Should you be unable to find a dealership willing to pay off your existing car loan to get you in a new vehicle, then I suggest you find out how far they will go and reallocate your tax refund accordingly. With any luck you may be able to use $1,000 of your refund for the car and the rest to pay off your card.

Try to keep at least $900 of your refund to pay down the card. Once you get your balance below 50 percent of your account maximum, your credit score should show signs of improvement, everything else being equal.

A short list of suggested uses for your tax refund:
  • Start or add to an emergency savings account. Your goal for this account is three to six months’ worth of living expenses.
  • Pay off or pay down high-interest debt. Generally speaking, you will want to pay debt that is costing you the most in interest charges or fees first.
  • Put some in a savings account for major purchase, summer vacation or holiday spending.
  • Spend some now. Heaven knows the economy needs it.
  • Add to your retirement fund or college-savings fund.

If your tax refund is more than about $600, you are giving the IRS an interest-free loan. Review your withholding and make adjustments so you are keeping all the money that is yours and only paying Uncle Sam what you owe.

One final word, don’t even think about getting a loan based on your refund so you have it faster. These are outrageously expensive, and if the refund doesn’t come through for any reason, then you owe the balance plus more “juice” than a truckload of oranges!

Good luck!