Getting a tax refund is a great feeling.
For many, it is an unexpected bonus, often larger than a typical paycheck.
In some ways, it is better than a bonus. If you get a bonus at work, you have to pay taxes on it. The tax refund comes with no such concerns.
The temptation is to use it on a vacation or a large purchase of some sort. Today we will make the case that the best place it can go is towards student loan debt. Paying down student loans is hardly sexy or fun, but the benefits are substantial.
Lasting Returns
The obvious benefit of paying down student loans is the immediate drop in the student loan balance. In reality, that balance drop is just the beginning.
By putting that money towards student debt, the lower balance means less interest accrues on the loan each month. This means that every single future payment will reduce the principal balance by more than originally planned.
As an example, suppose you get a $1,200 refund and use it to pay down a loan at 10% interest. Over the course of one year, you will spend $120 less in student loan interest on future payments. If it will take 5 more years to pay off the loan, the interest savings from making this one extra payment grows to $600! If there are ten years left on the loan, you are essentially doubling your money the day you use it to make an extra student loan payment.
Eliminate a Loan or even a Lender
If your tax refund is large enough to pay off a loan, it should be strongly considered. By completely eliminating a loan, future student loan bills will be lower. This means financial flexibility and more cash freed up each month to pay down other loans.
If the tax return is large enough to pay off the debt owed to any individual lender, it can be used to completely eliminate a student loan bill and student loan lender from your life. This should be an exciting option.
Avoid a Bad Purchase
Another advantage of using your tax refund to pay down student loans is that it helps avoid the temptation to use the money to make a bad purchase.
The classic example would be using the tax refund as a down payment on a new car. While the new car would certainly be more fun, the reality is that it is just creating more debt and another monthly bill. Car dealerships love advertising how a tax refund can be used to help buy a new car, but as someone with a student loan balance, the last thing you need is more debt.
What Does Your Lender Want?
You may think that the last thing you want to do is give more money to Sallie Mae, or whoever it is that you owe.
If hatred of your lender is making this plan difficult to swallow, think of it this way: Lenders want borrowers to make minimum payments. They make money on student loan interest. The more you spend on interest, the bigger their profits. If you attack the loan and pay it off quickly, it is far less profitable to the lender.
Using a tax refund to knock down a balance is a great way to reduce lender profits on the debt.
Let’s Make a Deal
If you have read this far into this article, you might be seriously considering changing your refund plans in order to pay down student debt.
If we haven’t convinced you yet, consider going 50/50. Use half the refund to pay down debt and use the other half to do whatever else you planned on doing.
Next year, when this decision presents itself again you can look back on your previous decision. Do the math to figure out how much your student loan payment saved and compare it to how you spent the other half of your money. Which option was better?
Some Exceptions to the Rule
Knocking out student loan balances isn’t always the best move.
For example, if you don’t have an emergency fund set aside for a rainy day, building up an emergency fund could be the best move.
Additionally, if you have a low interest rate on your student loan, it might make sense to do something else with the money. For example, if you have a 3.5% fixed-rate loan, putting the money in a savings account earning 5% would be more efficient.
Finally, we cannot ignore loan forgiveness. If you are on track to have your federal loans forgiven, paying extra just means less debt to forgive.
Bottom Line
A tax refund represents a unique opportunity to put a serious dent in your student loan balance.
You owe the money, and it will have to be paid back at some point. Why not do some damage now and save yourself some money on interest?
