5 Perks of Using Your Tax Refund To Pay Off Debt

Tax refunds aren’t free money. They’re reimbursements made to you by the state and federal government if you overpaid your taxes during the year. In other words, your tax refund is your money, which you’ve extended to the government in the form of an interest-free loan and are now getting back.  

The average tax refund is $3,138, according to the Internal Revenue Service (IRS). That’s a nice chunk of change for any taxpayer. But, if you have credit card debt or other high-interest loans, a refund can be more than just fun money—it can be part of a road map to a better financial future. 

Before You Use Your Tax Refund To Pay Off Debt

Paying off debt only works if you can keep from running it up again. To do that, look for the root cause of your debt. 

Your first goal should be to set aside at least one month of your net pay into a high-yield savings account, said Anthony O’Neal, a personal finance expert, professor at Virginia Union University, and bestselling author. He noted that over half of Americans can’t afford a thousand-dollar emergency.

“So, if life were to happen, they have to take out a payday loan, an interest loan, or a credit card,” he said. 

Setting up an emergency fund will help keep you out of debt and establish a financial safety net. This should be your first order of business before handling debts or making discretionary purchases.

Perk #1: Reducing Financial Stress

You may be tempted to use your tax refund to treat yourself to that big-ticket purchase or travel experience that you’ve been dreaming of. However, if you’ve been saddled with debt for some time, the best gift you can give yourself is peace of mind. 

Debt doesn’t just strain your finances; it can also take a toll on your mental and physical health. Studies have shown that individuals who struggle with debt are more likely to experience anxiety and depression, as well as physical symptoms, including worsened sleep, high blood pressure, and inflammation. 

Paying down debt today can contribute to a lower-stress life in the future and boost your financial health today.  

Perk #2: Saving Money on Interest

Using your tax refund to pay down debts, especially those with higher interest, could help you save money from incurring future interest. If you owe money to multiple accounts, there are a few different strategies to use. 

The Debt Avalanche Method

The first is known as the debt avalanche method, where you put the money towards the account with the highest interest. That way, you’re lowering the balance subject to the highest fees. 

“Think about it in the interest rate terms,” said Daniella Flores, a personal finance educator who teaches others how to tackle debt.  Suppose someone has $5,000 in credit card debt right now, with a 21% interest rate. What will that amount balloon to in five years or ten years? But if you were to use this tax refund as a kind of kickstart to paying off your debt, it’ll get your amount down to a more manageable level at least, and then you can start slowly chipping away at it after that.”

The Debt Snowball Method

O’Neal, on the other hand, teaches an inverted approach called the debt snowball method. To use this technique, line up your debts from smallest to largest and knock the smallest ones down first. 

“The reason why I like the debt snowball method is because it gives me a quick win,”  he said. “People are more…excited by seeing a win than they are just making a payment… Now, when you have that excitement, it sparks something in your mind like, ‘Yo, I could really do this.’” 

Perk #3: Avoiding Interest Accrual Post 0% APR Period

Credit card balance transfer offers typically provide an interest rate of 0% for at least six months and sometimes as long as a year or more. However, these introductory rates come with caveats, including transfer fees when you apply for the card and the loss of the 0% rate if you make a late payment. 

Paying off any accounts during the 0% APR period ensures that you don’t run out of the introductory rate’s terms. It also prevents you from making late payments and losing the APR. 

Perk #4: Boosting Your Credit Score

Paying off debt helps you improve your credit score in two ways: it reduces your credit utilization and decreases the chances that you’ll be late with future payments. 

Here’s how it works. Whether your lender uses the FICO or VantageScore credit scoring model, your credit score is based on a few factors:

• Payment history
• Credit utilization
• Length of credit history
• Credit mix
• New credit

Credit utilization is amounts owed in proportion to available credit. For example, if you have a total credit limit of $10,000 and you owe $5,000, your credit utilization rate is 50%. Credit utilization counts for 20%-30% of your score, depending on the model. So, paying down your debt will boost your score.

Payment history is even more valuable—it counts for 35%-41% of your score. Paying down your debt helps with this factor because it makes your overall debt easier for you to manage, reducing the chances you’ll make late payments in the future.

Perk #5: Focusing on Other Financial Goals

With strong credit, you’ll be better positioned to qualify for loans, credit cards, or housing leases. Plus, by addressing your debts first, you free up your money for more meaningful goals, such as saving for a house or a trip. 

“Every payment that you’re making towards your debt is a future payment toward yourself because, in the future, you’ll have that money for yourself instead to use,” said Flores. 

The Bottom Line

Your tax refund isn’t free money or a stroke of luck—it’s money you earned and are owed. This is a great opportunity to improve your finances, reduce stress, and help yourself down the line. 

Remember that celebrating yourself doesn’t have to cost you your entire tax refund. 

“Take a hundred dollars and go treat yourself to a nice dinner. Sit down with yourself and say, I’m about to attack this debt,” said O’Neal. “Keep that momentum and excitement going. So that way, you have the freedom to build wealth.”