In a NutshellLucky you, you’re expecting a tax refund in 2018! How will you use the extra money? You could take a vacation, upgrade your TV or stash the money in the bank. But if you’re focused on improving your credit next year, your 2017 tax refund could help you achieve your goal.
This article was fact-checked by our editors and reviewed by Christina Taylor, MBA, senior manager of tax operations for Credit Karma.
Depending on how you use it, your tax refund could help you improve your credit.
Every year, the IRS returns a huge amount of money to American taxpayers — more than $302.5 billion for 2016 tax returns. The average refund was $2,782. But if you’re getting one (and not everyone will) yours could be less or more, depending on how much you owed versus how much you paid in taxes throughout the year .
If you’re one of the lucky Americans who is owed thousands of dollars come April, you’ll have a decision to make. Should you pocket the money or spend it?
Many people already use their refunds in ways that could positively affect their credit. In fact, a Credit Karma Tax®survey found the majority of people expecting a refund for their 2017 taxes plan to save the money or use it to pay down various types of debt, such as credit card debt or student loans.
Here are a few ideas for how you can use your tax refund to your credit advantage:
Pay down — or pay off — credit card debt
You may have more than one type of debt, such as student loans or credit card debt, but it’s generally a good idea to aggressively tackle your highest interest debt. Typically, credit cards have pretty high APRs. In fact, according to the Board of Governors of the Federal Reserve System, the average commercial bank interest rate for credit cards is about 13.08 percent as of August 2017 . Depending on your credit history and financial situation you could be paying even higher interest on your credit cards.
“You can’t make money when you’re losing money,” says Matthew Buckley, CEO of the financial and options trading company Top Gun Options. “You should pay off the high-interest debt first. Every day that goes by you’re losing money. It’s like being in a sinking boat and feverishly using your bucket to bail out the rising water without plugging the hole.”
Start by looking at all the credit cards you have, their balances and their interest rates, and use your refund to wipe out as much debt as possible. Different financial experts will have different advice about how to approach the debt, so you’ll have to decide between paying off the card with the highest balance or the card with the highest interest rate.
What factors affect my credit score?
When you’re trying to improve your credit, it’s important to know what factors influence credit scores.
Six key factors are commonly used in calculating credit scores, although the actual scores can vary depending on the credit reporting agency pulling the information and the type of scoring model it uses. The factors are:
1. Credit card utilization rate – The amount of available credit you have compared to how much of it you’re using at any point in time is your credit utilization ratio.
2. Payment history – How reliably you pay bills on time is often a heavily weighted factor in credit scoring models.
3. Negative information – Derogatory marks like collections, bankruptcies, foreclosures and liens can have a severe negative affect on credit scores.
4. Average age of open credit lines – A longer credit history gives lenders more information to help assess your creditworthiness.
5. Total number of accounts – More accounts generally shows you’ve been approved by more lenders, and multiple types of accounts – credit cards, auto and student loans, mortgages, etc. – can also positively affect your credit.
6. Number of hard credit inquiries – When a lender or credit card issuer checks your credit in relation to a credit application, it creates a hard inquiry on your credit report(s). Multiple hard inquiries generally will more significantly affect your credit scores.
Pay down student loans, personal loans or a car loan
Have student loan debt? Join the club — 44 million Americans do too , according to the New York Federal Reserve. The average college graduate leaves school with about $34,000 in student loan debt , the organization reports.
Even if your refund is only a few thousand dollars, putting it toward your student loan could speed up how fast you pay off this debt and potentially reduce your monthly payment. If you only have several thousands of dollars left to pay on your student loans, using your refund will have even more impact.
The same thing goes for a car loan or a personal loan, the latter of which often has a higher interest rate. While it may seem counterintuitive to pay off low-interest debt first instead of credit card debt, you’ll have the satisfaction of getting rid of at least one creditor.
Your debt-to-income ratio could also improve if you reduce the amount of your total debt. Debt-to-income ratio – your total monthly payments on any kind of debt divided by your gross monthly income – isn’t a credit scoring factor, but it can be an indicator of your overall credit health.
Pay off anything in collections
When you fail to pay a bill you owe, the creditor may choose to put the debt into collections in an attempt to get at least some of the money back from you.
Collections are negative marks that can appear on your credit reports and negatively affect credit scores. The Fair Credit Reporting Act limits the amount of time a collection can stay on a credit report to seven years. Once a collection has cycled off your credit reports, it will no longer affect credit scoring.
However, if you can’t wait seven years to improve your credit, consider that lenders are likely to look more favorably on a paid collection account than one that’s still outstanding. Using your tax refund to pay off a collection could help reduce that debt’s negative affect on your credit.
Get a secured credit card
Using your refund to pay the deposit for a secured credit card can help boost your credit health. Secured credit cards are a way to build your credit, especially if you have no credit history or a poor credit history.
Secured credit cards require a deposit. The initial deposit is equal to your credit line on the card. For example, pay a $600 deposit and get a $600 credit limit. Many secured cards also report to at least one, and often all three, major credit bureaus, so making on-time payments or paying off your balance in full every month could improve your credit.
You could use part of your refund to pay the deposit for a secured card, and the rest to pay down or pay off any purchases you charge. Not only will this aid you in avoiding interest charges, it will also help you build a positive payment history on your credit report.
Kickstart your emergency fund
Establishing an emergency fund is another indirect way to boost your credit scores. Having cash in the bank to cover emergency expenses can mean you won’t have to put those unexpected costs on a credit card or take out a personal loan to cover them. You’ll have greater flexibility to make judicious decisions about how you use credit.
A good rule of thumb is to have between three to six months of expenses saved — maybe even more if you have many dependents. As an example, if your monthly expenses are $3,000, aim to save between $9,000 and $18,000 in your emergency fund.
Not having to rely on credit to cover emergency expenses can help keep your credit utilization rate low, which in turn helps protect your credit scores.
It’s probably safe to say no one likes the process of filling out their tax return. But, the possibility of getting money back from Uncle Sam makes Tax Day one of the best days of the year for many Americans.
Rather than spending your refund on short-term goals like shopping or travel, why not put it to work toward your long-term goals? Paying down high-interest debt and creating a financial cushion for yourself can be a smart, credit-building use of your tax refund.
Christina Taylor is senior manager of tax operations for Credit Karma. She has more than a dozen years of experience in tax, accounting and business operations. Christina founded her own accounting consultancy and managed it for more than six years. She co-developed an online DIY tax-preparation product, serving as chief operating officer for seven years. She is the current treasurer of the National Association of Computerized Tax Processors and holds a bachelor’s in business administration/accounting from Baker College and an MBA from Meredith College. You can find her on LinkedIn.