Expecting a tax refund this year? Already know how you’re going to spend it? Before you start daydreaming about that new plasma TV or trip to the beach, consider using your check to do some serious good…for your credit score. Your credit score is key to your current and future financial well-being. A good score means access to loans and credit at reduced interest rates, which can save you hundreds each month.
The average tax refund in America is $2800. Depending on your situation, $2800 can be enough to take your credit from subpar to stellar, setting you on the right financial path for the future.
What’s dragging your credit down?
Your credit score is calculated using a few different factors – the two that have the most influence are payment history and level of debt.
Your payment history is a record that shows whether you pay your bills on time, late, or not at all each month. If you miss a payment, a late entry is added to your credit report and your credit score falls. After six months of nonpayment, your creditors and lenders typically charge-off your account and send it to a collection agency (a charge-off hurts your credit rating for up to seven years).
Level of debt is the amount of your credit card balances compared to your credit card limits. Your credit score takes a hit as your credit card balances get closer to your credit limits.
Use you tax refund to strengthen your payment history and lower your level of debt. You’ll see a marked improvement in your credit score, and further insulate yourself from charge-offs and phone calls from collection agencies.
Which debt should I pay off first?
The hard part is figuring out exactly how to distribute your tax refund across various credit card bills, loans, and collections accounts. Which do you pay down first for maximum impact on your credit score?
First, bring your past due accounts current. You don’t want any more of your accounts to fall into the “charged-off” category. That would be a big blow to your credit report, one that takes seven years to recover from. Making sure this doesn’t happen should be your first priority.
Second, turn your attention to any collection accounts in your name. Before sending your payment to the collector, try to negotiate removal of the negative entry from your credit report in exchange for payment. Some will agree to this, others won’t. If the collector agrees, removing the charge-off from your credit report will result in a greatly improved credit score. If they don’t agree, it will stick on your report up to seven years from the time of the charge-off.
Third, pay down credit card balances to below 30% of their limits. If you still have money left over from your refund, use it to pay down remaining credit cards balances to below 30% of their limits. For instance, if you have a $1200 balance on your Visa that has a $1500 limit, try to pay down your balance to below $500.
Finally, start an emergency savings fund. Put any remaining tax refund money into a savings fund. This is a crucial step to breaking the debt cycle. If something unexpected happens (and it always does, doesn’t it?), you need to be able to depend on something other than your credit cards. Even if your first deposit into savings is just $50, that’s $50 less credit card debt you’ll owe in the future. Distributing your tax refund according to these priorities is sure to give your credit a much-needed boost.
One of the reasons people postpone credit repair is because they simply don’t have the money to pay off accounts that have a negative impact on their credit. Using extra income, like a tax refund, lets you improve your credit without having to cut into your regular budget.