Using Your Tax Refund to Boost Your Credit Score

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May 19, 2024 at 5:12AM UTC
Getting a tax refund can feel like hitting the jackpot. But what you’ve really won is money you’d earned all along.
Instead of treating it like a gift, put it to use — ideally, by helping yourself build good credit, which will last long after the thrill of receiving that refund is gone.

How to spend your tax refund wisely

The average tax refund for the 2018 filing season was $2,893, according to the IRS. That can be a major windfall, especially because many households don’t have substantial savings to start with. The median total savings account balance among U.S. households was about $7,000 in 2016, according to a ValuePenguin analysis of U.S. Federal Reserve data. But experts recommend saving three to six months of expenses for emergencies, and $7,000 won’t likely cut it for many households.
That means, for most people, there are wiser uses for a tax refund than funding a trip, replacing the living room furniture or treating yourself to a laptop or TV upgrade. Instead, take this opportunity to build a solid financial foundation that will serve you year after year. Focusing on your credit — and savings, if you don’t have much — are the best ways to do it.

4 tips for boosting your credit with a tax refund

Those with credit scores of 670 or higher, based on the FICO credit-scoring model, usually get the best rates and terms on financial products. The higher the score, the better. Good credit could mean lower interest rates on a car or home loan in the future, an easier time renting an apartment, or access to credit cards with valuable cash back or travel rewards.
By following these strategies, using your refund could boost or protect your credit score.

1. Fund an emergency savings account

Without savings, you’re more likely to rely on credit cards to pay for necessities if, say, you suddenly lose your job or need to cover an unexpected car repair. Save your tax refund as a precautionary measure: Once you have emergency savings to fall back on, you can rest easier knowing your credit score won’t take a hit due to a maxed-out card or lots of new credit inquiries when you’re low on funds.
Using three to six months of expenses as an emergency savings goal, you can save closer to three months’ worth if your income is steady, said Trent Porter, a certified financial planner and certified public accountant at Priority Financial Partners in Colorado. Aim for six months if your earnings fluctuate quite a bit.
It’s best to use most, if not all, of your tax refund to start a savings account if you have no money set aside at all. Or you can use it to bring a starter emergency fund closer to its ideal balance. If you have money left over, turn now toward getting debt under control.

2. Pay down debt

Bringing down your balances is the primary way your refund can directly influence your credit score, Porter said.
The most important factor in your credit score is payment history, which accounts for 35% of it, according to FICO. With a juicy tax refund, you can’t go back in time and eliminate missed payments from your credit report. But you can influence the second-most important component in your score: amounts owed.
Target your revolving credit accounts, which are typically credit cards and home equity lines of credit, Porter said. When you pay these down, your credit utilization ratio, or the amount of debt you carry compared with your overall credit limit, shrinks. The less of your available credit you use month to month, and the closer you get to paying off purchases in full, the more credit- scoring models will reward you.

3. Apply for a secured credit card

New to credit, or hoping to restore a poor credit score? A secured credit card can help you build positive payment history, even when you don’t qualify for a traditional card. A secured card requires a deposit up front, which becomes your credit limit, but otherwise functions like any other credit card. The catch for many is that deposit — which you can cover with a tax refund.
Making small purchases with a secured card and paying them off each month can bolster your score. Plus, adding this different type of credit to your profile — if you only had a student loan or car loan previously, for instance — can improve your credit mix, Porter said. But because that only makes up 10% of your FICO score, it won’t have a huge impact.

4. Get help from a pro

Talking to a financial professional won’t just leave you with credit-building strategies. It could also get your monthly budget and even retirement savings on track, which can mean better short- and long-term financial stability and less reliance on credit cards in the future.
For general budgeting and credit advice, search for a local nonprofit credit counseling agency affiliated with the National Foundation for Credit Counseling. An initial, one-hour consultation is free, and most services after that are no- or low-cost.
If you’re eager for advice on retirement, investing, insurance, estate planning or other topics, using your refund to meet with a fee-only certified financial planner may be a good bet. Fee-only financial advisers do not receive commissions for selling financial products. They do charge more than credit counselors, though. If you only need a few sessions to talk through your personal financial plan, look for an adviser who charges hourly.
Search for an adviser using a database like the one offered by the XY Planning Network, an organization of advisers geared toward Generations X and Y, or Millennials (roughly, anyone born between 1965 and 1996).

Why you may not want a tax refund after all

When you get a tax refund, that’s proof that you overpaid the government throughout the year. More money in your paycheck means more money to save month after month, and that money can grow fast — thanks to compound interest — if it’s set aside in a high-yield savings account or invested.
If you don’t foresee your income or lifestyle changing in the next year, you can likely safely decrease the amount of tax your employer takes out of your paycheck by filling out a new Form W-4 at work, Porter said. The more allowances you claim on the form, the less tax is withheld, as paradoxical as that might seem. In other words, increasing your allowances may reduce your refund.
Fill out a new Form W-4 when you get married, divorced, have a child, or begin or end a second job. Set up an appointment with a tax preparer if you foresee a change to your financial situation in the next year. A tax pro can help you figure out the best withholding strategy so that you get the pay you deserve throughout the year — without waiting until an annual tax refund hits your bank account.
This story originally appeared on LendingTree.

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