The No. 1 thing Americans plan to do with their tax refunds this year is pay down debt, according to GoBankingRates. Overall, 27% of Americans plan to use their refund from the Internal Revenue Service (IRS) to reduce their debt. That's far beyond the three activities tied for the No. 2 use of a tax refund this year at 9% each: Making a major purchase, saving, and investing.
Millennials stand out as the shining star generation in making the smart choice with this windfall. Among millennials aged 25 to 34, 38% of respondents said they plan to use their tax refund to reduce debt. Then, among people aged 35 to 44, 32% will pay debt with their refund, and 36% of people aged 45 to 54 will. Fewer folks who are approaching retirement or are already in retirement are applying their tax refund toward debt repayment. Among Americans aged 55 to 64, 20% plan to pay down debt with their tax refunds, and only 19% of people 65 and older plan to.
Paying down high-interest debt and any debts in collection is a noble goal, and it should be first in the order of financial operations. The average amount of debt owed by individuals in the U.S. is $52,458, according to GoBankingRates. The U.S. owes a total of $13.5 trillion in national debt, according to the Federal Reserve Bank of New York, a historical high.
How debt hurts your finances
Debt can pose a danger to an otherwise healthy financial life. Monthly debt payments tie up your immediate income, and the interest just drives the balance back up as soon as you've made a minimum payment. Debt service pushes aside more productive uses of your cash, such as saving in an emergency fund, saving for a down payment, saving for retirement, and investing. If you don't already have a robust emergency fund, you're setting yourself up to take on more debt when emergencies inevitably occur. You'll wind up pulling out your credit card to pay for sudden events, like a car repair or emergency room visit.
High debt levels can also pose a more basic danger: You won't have enough money to make ends meet each month. This is an especially serious risk for retired Americans, many of whom live on a fixed-income budget. The average Social Security benefit payment to retirees is $1,461 per month. More than 20% of married people and 44% of single people depend on Social Security for 90% or more of their income. Meanwhile, Americans 65 and older owe an average of $48,066.73 in debt. It's not hard to see how debt payments can pose a real financial hardship, especially when combined with necessary expenses for food, shelter, healthcare, and everything else.
That's why reducing high-interest debt and debts in collection is one of the most important moves that people nearing retirement or in retirement can make. It can stop a severe drain on your monthly expenses, putting you on sounder financial footing. Once debt service is removed from the equation, you'll have a much easier time making ends meet, and then you can start using your surplus for savings, whether that's for retirement, travel, or a down payment on a house or car.
How to think about debt reduction
Thinking strategically about your debt is key to formulating a debt-reduction plan. Look at your different debts and evaluate what each debt is doing for you -- or how it's working against you.
You receive tax advantages for carrying certain types of debt. Interest on your mortgage debt is tax deductible, and so is interest on your student loans. Then there's the added value of what you're enjoying from the liability you carry -- the mortgage means you have shelter, and student debt provides an education otherwise out of reach.
But interest on credit card debt is not tax deductible, and the interest rates on this type of debt are reaching historic highs. You can easily end up owing more in interest than you initially owed in principal.
Here's an illustration: Imagine you have a $5,000 balance on a credit card that carries a 14% interest rate. If you make a minimum payment of $25 each month, it would take you more than 20 years to pay off the relatively small original debt and by the end of the period, you will have paid nearly $5,887 in interest alone -- more than the initial amount you owed.
So if you have several types of debt, including a mortgage, student loans, an auto loan, and credit card debt, start with credit card debt. Vanquish all high-interest credit card debt at your first opportunity, as credit card debt offers no tax advantages and carrying a balance can cost you far more money. Then tackle your auto loan if you have one, because while it conveys the benefit of driving your car, there are no tax advantages. Mortgages and student loans have much lower interest rates, so it's reasonable to keep paying those at a steady monthly rate, to keep enjoying the tax benefits over time.
How to pay down debt the fastest
If you owe debt on more than one credit card, there are two contrasting methods for paying it off.
The first technique is called debt snowball. Using the debt snowball method, first focus on paying off the credit card with the smallest balance. Shovel all the extra money you can scrounge up toward it until it's paid off. You'll need to keep paying the minimum balance on all your other debts, of course, to keep them out of collections. Once the smallest balance is paid off, then you move to the credit card with the next-smallest balance, putting all your disposable income to work paying it off. This works well to incentivize people early on in the debt repayment process, by providing the feeling of accomplishment and a psychological boost.
The second debt repayment strategy is called the debt avalanche. The debt avalanche method prioritizes paying debt off according to the interest rate, with the highest first. You direct all the money you can toward the credit card with the highest annual percentage rate (APR). (APRs can be found in the small print on your credit card information.) Once the highest is paid off, you move to the next highest. Work down the line until all your credit card debt is paid off. This is the most mathematically effective debt repayment strategy.
Either of these methods can be used when putting a tax refund toward debt. About 70% of Americans are expecting a tax refund, and the average amount projected is about $3,000.
If this year's tax refund isn't enough to extricate credit card debt from your life and your budget entirely, there are two other ways to pay down debt more advantageously. Using a debt repayment calculator can help you figure out the various scenarios available to you.
The first option is consolidating your debt with a personal loan. Yes, it entails taking out a loan from a financial institution, but personal loans usually have interest rates in the neighborhood of 10%, especially if you have an excellent credit score.
The second possibilty is rolling over your existing balances to a credit card with a lower or even 0% APR. Many credit cards have introductory offers with very low or no interest rate charges for specific periods of time. If you go this route, make sure to pay off the balance before the introductory rates ratchet up, ensnaring you back in the high-interest credit trap.
Whatever you do with your tax refund, make sure you're not neglecting high-interest debt that's dragging down your budget.