What to do with tax refund? Pay down debt

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Dear Debt Adviser,
I need to figure out the best way to use my tax refund to my advantage. I will be receiving a tax refund of $6,200. I have a lot of debt and I make about $30,000 per year. I just bought a house and have made my first payment. My debts are as follows:

  • Friend, $600 (I intend to pay this off as soon as possible).
  • Medical bill, $345 (zero percent interest, $69 per month).
  • Store credit card, $2,040 (zero percent interest until April 2011, then 22.99 percent, $66 per month).
  • Credit card, $5,712 (10.99 percent interest, $85 per month).
  • Mortgage, $63,215 (5 percent interest, $460 per month).

I have no savings and no retirement accounts. I am worried about my financial future. I am 27 years old.
— Matthew

Dear Matthew,
I understand how challenging it is to get by in today’s economy. My son, Geoff, is about your age and while he is enjoying the good life in San Diego, he faces the same challenges that you do every day. So, here’s the same advice I’d give him.

First, pay your friend. Good friends are rare. Friends who lend money are still rarer. But, friends who pay money back are golden!

Next, I want you to take $1,000 of your tax refund and stash it in an emergency savings account. Your goal for this savings account is to someday fill it with at least six months’ of living expenses.

For the remaining $4,600 of your tax refund, I recommend that you pay down your credit card debt of $5,712. Then, over the course of the next six months, I want you to pay off the remaining balance of approximately $1,112 and your store credit card balance of $2,040. You can do this if you make monthly payments of $191.32 to your credit card and $340 to your store card. You are probably saying, “Has the man lost his mind?” Not at all. This is doable, you just need a plan.

The Plan: With an income of $30,000, you should be bringing home about $1,833 per month. Your mortgage is $460 and your total debt payment would be $531.32 plus $69 per month to cure your medical bill. That leaves you $772 per month for the remainder of your expenses. This is where the planning comes in. You will need to adjust your spending so you can pay all other expenses from the $772 left for the month. Keep in mind that the sacrifices you will need to make for this to work will be for only six months, and at the end you will be able to celebrate the holiday season debt-free except for your mortgage.

Lastly, I want you to concentrate on your emergency savings account. It may be tight, but I recommend saving the $10,000 or so that would equal six months’ of living expenses by the time you turn 30. It is very important to have this cushion of savings to avoid unwanted debt and get you through any employment interruptions. Without money in savings to fall back on, every time an unexpected expense shows up, you’ll end up back on the debt treadmill. Save the treadmill for the gym.

Once you have your debts paid off, the good stuff happens. To pay for all that good stuff, I want you set up an additional savings plan. I want you to save money that you don’t have yet. How cool is that! Commit to placing half of all future employment raises, tax refunds and bonuses into savings, for travel, a wedding, retirement or otherwise. The other half you can spend with the assurance that you have more bases covered than the New York Yankees.

A final savings-builder tip is to reduce your income tax withholding so you have $1,200 or less coming back next year. You can use the money in your paycheck more than the IRS needs it. By the way, if you’re ever in San Diego and run into Geoff in a 20-something hangout, be sure to say hello for me, will you?

Good luck!

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