March 11, 2021
Shawn Lane
Consumer Credit Expert
It’s easy to treat a tax refund like free money – and many people do. When a check for hundreds or even thousands of dollars show up in the mail, who wouldn’t feel like they’ve just won the lottery?
But a tax refund is just that – a refund – and because that money was yours to begin with, it’s less like winning the lottery and more like picking up an extra paycheck on a leap year. So before you go spending it on a vacation or new TV, consider using that money to improve your financial situation.
Here are some of the best ways you can use this year’s tax refund to improve your credit.
1. Pay Off Credit Card Debt
One of the most important components of a credit score is the credit utilization percentage, which equals the current balance divided by the total credit limit. A high ratio suggests that a borrower may be relying too much on credit to fund their lifestyle, while a low ratio indicates a more financially stable borrower.
Credit scoring models penalize you as your utilization percentage increases, and cardholders with ratios above 30% will see a larger drop. If you currently carry a credit card balance, you may have a high utilization ratio bringing down your score.
Using your tax refund to pay down the credit card balance could improve your credit score. Let’s say you owe $4,000 on a credit card with a $10,000 total credit limit, so your utilization percentage is 40%. You get a $2,000 tax refund and apply all of it toward your credit card debt, so now your utilization percentage is 20%. While this is still higher than recommended, it’s an improvement that will likely result in a better score.
Having a better credit score could also let you qualify for a 0% APR offer on a credit card. In this example, you could transfer your existing card balance to the new card and pay off your debt while saving on interest. This would help you become debt free faster, which will also improve your utilization ratio and credit score.
2. Get a Secured Credit Card
If you have poor credit or no credit and don’t currently have any loans or credit cards, a simple way to improve your credit score is to open a secured credit card.
Unlike a regular credit card, a secured credit card requires a deposit that will serve as the credit limit. The deposit acts as the collateral for the card issuer, in case you default on the card. The deposit is usually at least $200. If you get a tax refund, you can use the proceeds as the deposit.
Once the card is open, make sure to pay all your bills on time because this will have the biggest positive impact on your credit score. Next, keep the utilization below 10%, which may be more difficult to do with such a low credit limit.
For example, if the total credit limit is $200, you shouldn’t have more than a $20 balance at any time. As you continue to use the secured card responsibly, your credit score will improve.
3. Save for an Emergency Fund
Many consumers rack up credit card debt because of unforeseen expenses, like fixing a broken furnace or replacing all four tires on a car. If you can’t pay for an emergency in cash, you may rely on a credit card or take out a loan you can’t afford. Saving the tax refund in an emergency fund will let you pay for surprises out-of-pocket instead of depending on credit.
Most people should have between three to six month’s worth of expenses in an emergency fund. If you have kids or an unstable job, aim for the higher end. Go through your monthly expenses and see how much you need to survive each month. Then, decide how many months you want to save for.
Keep the emergency fund in a savings account and don’t use it unless an unforeseen emergency comes up.
The Bottom Line
Here are some of the best ways you can use this year’s tax refund to improve your credit.
1. Pay Off Credit Card Debt
One of the most important components of a credit score is the credit utilization percentage, which equals the current balance divided by the total credit limit. A high ratio suggests that a borrower may be relying too much on credit to fund their lifestyle, while a low ratio indicates a more financially stable borrower.
Credit scoring models penalize you as your utilization percentage increases, and cardholders with ratios above 30% will see a larger drop. If you currently carry a credit card balance, you may have a high utilization ratio bringing down your score.
Using your tax refund to pay down the credit card balance could improve your credit score. Let’s say you owe $4,000 on a credit card with a $10,000 total credit limit, so your utilization percentage is 40%. You get a $2,000 tax refund and apply all of it toward your credit card debt, so now your utilization percentage is 20%. While this is still higher than recommended, it’s an improvement that will likely result in a better score.
Having a better credit score could also let you qualify for a 0% APR offer on a credit card. In this example, you could transfer your existing card balance to the new card and pay off your debt while saving on interest. This would help you become debt free faster, which will also improve your utilization ratio and credit score.
2. Get a Secured Credit Card
If you have poor credit or no credit and don’t currently have any loans or credit cards, a simple way to improve your credit score is to open a secured credit card.
Unlike a regular credit card, a secured credit card requires a deposit that will serve as the credit limit. The deposit acts as the collateral for the card issuer, in case you default on the card. The deposit is usually at least $200. If you get a tax refund, you can use the proceeds as the deposit.
Once the card is open, make sure to pay all your bills on time because this will have the biggest positive impact on your credit score. Next, keep the utilization below 10%, which may be more difficult to do with such a low credit limit.
For example, if the total credit limit is $200, you shouldn’t have more than a $20 balance at any time. As you continue to use the secured card responsibly, your credit score will improve.
3. Save for an Emergency Fund
Many consumers rack up credit card debt because of unforeseen expenses, like fixing a broken furnace or replacing all four tires on a car. If you can’t pay for an emergency in cash, you may rely on a credit card or take out a loan you can’t afford. Saving the tax refund in an emergency fund will let you pay for surprises out-of-pocket instead of depending on credit.
Most people should have between three to six month’s worth of expenses in an emergency fund. If you have kids or an unstable job, aim for the higher end. Go through your monthly expenses and see how much you need to survive each month. Then, decide how many months you want to save for.
Keep the emergency fund in a savings account and don’t use it unless an unforeseen emergency comes up.
The Bottom Line
When you get your tax refund, go through your finances to decide the best way to allocate the funds. If you’re not sure what the priority should be, you can split the refund between a credit card balance and your emergency fund.
Do you have credit questions or need help improving your credit scores? Schedule a free credit analysis with a Financial Renovation Solutions credit consultant today.