The new year is here, and tax season is coming up very soon and for those of us who are lucky enough to get a nice tax refund, the question comes up on what it should be used for. Should you put refund away for a rainy day, or should you take the opportunity to get rid of some of your debt and make your monthly costs easier. Both options seem like a good choice, but which one is the best choice. That’s what I want to talk about, so we can all make the most of this tax season. For those who must pay and don’t get a refund, you can use this for another situation when you have more money coming in.
For the people who think that saving the money would be the best option there are a lot of positives having liquid money set aside. In my experience I seem to always have bad luck as soon as my refund check comes in where I suddenly need to fix something on my car or have a payment due for a big bill the next day. The point being is that life can be very inconvenient and if you have fallen behind on your savings this could be a chance to relieve some stress and give you a financial buffer. It’s always good to have a few months of bills saved up for a just in case scenario and if you aren’t where you want to be then saving could be the best option.
You could also consider the way you can make money off your refund and invest it into your 401k or even starting your own IRA. This is the part where you can do some math to see which option between saving money and paying off debt is more beneficial for you. You can compare how much money you save from paying off a debt early versus how much money you would make by investing the money. First look at the debt you want to pay off (i.e. a student loan), see how much you are paying in interest every month and how many months you have left on it. So, if you pay $20 a month in interest alone and have 2 years left on the loan then you do: $20 X 24 months = $480 in interest payments you won’t have to pay if you pay off the loan now.
Now, you can compare the money you save from paying off the loan to how much money you can make within the 2-year window you would be paying on the loan. If an IRA account is the route you want to take than you will be meeting with a banker or adviser who will be able to discuss with you options and interest rates on your potential account, so you can see what you can make. If you make less money than $480 then it would be more beneficial to pay off the debt, but if it’s more than investing would be better. Two things to remember when calculating this is to remember to factor for interest payments only. The principal or original loan amount must be paid no matter what which means the only part you have control over is the interest payments. Also, if you do look to invest your money than most likely you will not have access to that money for a while. It will be making you money, but if a bill comes up that you need to pay you won’t be able to use your investment money without a penalty.
If you don’t like the idea of not having access to your money at this point, but also aren’t sure if spending it all on a bill would be best there is another way to help with your decision making. Sit down and add up all your monthly expenses and separate them into two columns, debts that must be paid and debts you can cut back on like eating out or shopping. Add those debts up to get your total monthly expenses while factoring in an allowance for personal things you like. When you have this number, you need to decide how many months you want to have saved to feel comfortable financially, and multiply your total monthly expenses by that number of months. Once you have saved up that much then you have the security you want so you can be more aggressive with paying off debts or if you are comfortable with both spend the money on something for you. Go on vacation or treat yourself to something you have always wanted.
There is never a clear answer on what you should do. You are the one who understands your situation the best and sometimes your decisions are already made for you when it comes to finances, but I like to keep one thing in mind when planning with money. The point of making more money is to improve your quality of life. Paying off debt helps obviously because then you have more disposable income to do the things you love and, so you can continue to do them for a long time. Will paying off a bill free up enough money, so you can take an art class you’ve been wanting to take? Or, maybe this refund is enough to cover that vacation to Ireland you’ve always talked about (personal goal). It’s always good to reward yourself with your hard work, just get back to your financial plan after so you can keep treating yourself.