4 Ways You Can Use Your Tax Refund to Work on Your Credit
Spending your tax refund on something fun can be tempting. But consider an alternative. Check out four ways you can use your tax refund to work on your credit.
Each year, millions of Americans pay income taxes to the federal government. But if you're among those who paid more taxes than you owe, you'll receive some of that money back from the IRS when you file your tax return.
The size of your tax refund may be big or small, depending on several factors. Your annual earnings, withholdings, tax bracket, and any deductions or credits you claim can all play a role in the amount of money you get back from (or owe to) Uncle Sam. In 2020, the average tax refund that the IRS sent to tax filers was $2,741.
Whatever the amount you receive from the IRS, it's additional money that you probably don't have factored into your regular budget. So, figuring out how to spend that extra cash can be exciting. Will you spend your tax refund on something fun and indulgent, like a shopping spree or a weekend getaway? Many people do. Or will you put your tax refund toward something that will make your financial life easier?
One idea you may want to consider is using your tax refund to help your credit. No, you can't buy a better FICO® Score. That's not how the system works. But if you spend your tax refund on one of the four ideas below, there's a chance your credit could change as a result.
1. Bring past-due accounts current.
Many people fall behind on their bills when they experience financial hardship. If you're currently in this predicament, those past-due accounts are probably one of the first areas you should focus on when you receive your tax refund.
Making late payments to creditors can hurt you in several ways. In the short term, you might owe late fees to your creditors if you can't make your payment by the due date. If you fall behind on a credit card account, there's a chance your card issuer could increase your interest rate too. And perhaps worst of all, late payments may damage your FICO® Scores when those delinquencies show up on your credit reports.
On a positive note, if you can bring a delinquent account current again before it progresses to a charged-off status, your FICO Score might escape additional damage. Here's an area where your tax refund could be put to good use. Paying off a past-due balance may also help you avoid additional fees or rate increases from your creditor as an added bonus.
2. Pay down your credit card balances.
Paying down your credit cards can be another smart way to spend your tax refund (or any other sudden influx of cash). According to the Federal Reserve, the average APR on credit cards that assessed interest was 16.28% during the last quarter of 2020. So, if you use your extra cash to eliminate some or all of your credit card debt, it could potentially save you a bundle in interest fees and help increase your FICO® Scores.
3. Consider opening a secured credit card.
A well-managed credit card can be a helpful tool if you're trying to establish a credit history. But qualifying for a credit card with no credit or a lower FICO® Score can sometimes be tricky. Some lenders might not be willing to approve your credit card application in this situation.
There is, however, a certain type of credit card account that's generally easier to open. It's called a secured credit card. A secured card may be an option even if your credit history is damaged or nonexistent.
With a secured credit card, you put down a deposit with the issuing bank when you open the account. This is where your tax refund can come in handy. The security deposit lowers the risk involved for the lender. As a result, a card issuer may be willing to work with you despite the fact that you're a higher credit risk.
4. Build an emergency fund.
Using your tax refund to fund an emergency savings account won't change your FICO® Scores in a direct sense. If you have some cash tucked away, it could help you when unexpected financial emergencies arise.
An emergency fund gives you an added source of cash, so you don't have to use credit cards to get you through a financial bind. (Remember, high credit card utilization might have a negative credit score impact.) Some extra money in the bank can also help you avoid late payments for a time if you experience a job loss or another reduction in your income.
Make a plan
Before you spend one dollar of your tax refund, it's wise to take a moment and write out your plan. You can list all of the potential credit-friendly ways to use those funds. Then, prioritize your "refund wish list" from most important to least important. Using your tax refund to work on your credit might not be as fun in the short term as some other purchases, but it could give you some financial peace of mind that will last a lot longer.
Michelle Black, Founder of CreditWriter.com is a leading credit expert, financial writer, and speaker with nearly two decades of experience. Her work has been featured with major outlets such as Forbes, Reader's Digest, and U.S. News and World Report.