Using Tax Returns to Pay off Personal Loans and Other Debt

In a previous post we discussed the problems that can arise from paying off tax debt with a credit card. Now, however, we will discuss the opposite, using money gained from your tax return to pay off debt – personal loans or credit card debt, for example. While the former is a bad idea (see the blog post for reasons why), the latter can be a good practice.

With spring comes the much anticipated tax return. Many people look at the tax return as extra money and a means to splurge a little on themselves. It is rarely thought of as a means to pay off debt. While splurging on yourself is much more enjoyable at first, I recommend looking into paying off personal loans or other debt, like credit card debt. However, once you have made the decision to do this, there are some things to keep in mind about these different types of debts which may influence your decision as to which ones you will pay off and how you will pay them off (i.e. will you pay off your debt all at once or in installments over time, etc.). Here are some factors to keep in mind:

Using your tax return to pay off personal loans

Some personal loans have an early payment penalty, which means if you pay your personal loan off early you are charged a fee. This is common with large secured loans like mortgage loans or student loans. Also, borrowers with bad credit history sometimes have an early payment penalty on personal loans. If you do have an early payment penalty, it may make more sense to hold off and pay the loan off as scheduled, rather than using your tax return to pay it off all at once.

Using your tax return to pay off debt (like credit card debt)

If you are thinking about using your tax return to pay off debt, it may be a good idea to pay off the debt that has the highest rate of interest, such as paying off high interest credit card debt before paying off your lower interest personal loan. However, the Credit CARD Act of 2009 says that borrowers that make steady payments on their credit cards for six months may qualify for a lower interest rate. So again, you may want to pay off your debt in installments using your tax return as opposed to all at once. But if it is the case with your debt that it is much higher interest than your personal loan debt, it may make more sense to use your tax return to pay off your credit card debt and not your personal loan debt.

Reducing the amount of taxes you pay throughout the year in order to pay off your debts throughout the year

It is also possible to reduce the amount of taxes you pay throughout the year. If your return is consistently of a considerable amount, you are essentially giving the government more money than is necessary throughout the year. By figuring out how to reduce your tax payments (putting yourself in a different tax bracket, for example – through legal means of course), you can use the extra money you receive throughout the year to help pay off your debt throughout the year, and will also not be so reliant on using credit cards and personal loans.

A quick example of what this looks like: If you are a single worker (no spouse) and no one claims you as a dependent, let's say you claim 2 in the personal allowances section of your W-4 instead of 1. Both ultimately result in you paying the same amount of taxes to the government, but I believe that claiming 2 instead of 1 would result in you having more money available to you throughout the year as opposed to getting it all back at the end of the year. In any case, it is recommended that you consult a professional if you are looking to use your tax return to pay off your debt throughout the year – which can be a good practice.