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The IRS gives tax refunds to many people who overpaid, but most people don’t know what to do when they receive a check in the mail.
Frugal living expert Kate Cadden recently received an award Question from one of his viewers About whether you should save your tax refund or pay down debt.
While there are individual elements to consider in any financial situation, Caden offered comprehensive tips that can help people assess their finances and determine the right steps to take for their tax refund.
When to Save Your Tax Refund
Caden suggests having a financial buffer that can cover at least one month of living expenses, while highlighting that an emergency fund that can cover three to six months of living expenses is even better. These reserves were the deciding factor for Caden’s analysis.
“If I didn’t have any of this, I would definitely save a little bit for a mattress,” Caden said in her video.
If you don’t save money, you run the risk of taking out a loan for an emergency expense. He said $500 and $1,000 emergency expenses are fairly common, so you should have at least that much set aside.
When to Pay Off Loans With Your Tax Refund
His opinion changes if you already have a financial buffer or emergency fund. In this scenario you have enough cash to deal with short-term emergency expenses and you can be more aggressive in paying off the debt.
“If you were set up like this, I could get out of debt,” Caden said.
Caden then said that anyone who is in debt should prioritize high-interest debt, especially credit card debt. Those APRs often start at 18% and can exceed 30% in some scenarios. That type of debt can be financially crippling if you don’t address it over a long period of time. While mortgages and personal loans also come with interest payments, they are often not as severe as credit card debt.
Getting rid of high-interest debt will make it easier to eliminate other debt because your interest payments will reduce over time. However, it is equally important to determine how you got into debt. Bad financial habits can compound in the long run, and people who are overspending may have to make extra efforts to make ends meet.
Tax refunds can serve as a second chance, but if you don’t change your financial situation, you’ll fall back into debt.