I was working with a prospect recently who told me that they like to get a big tax refund each year. They then use the money to pay down their credit cards. That way, they start each year with a zero balance.
I told them that paying down their high interest credit cards was good. What could they be doing better?
For one, a concern of middle class families is monthly cash flow and trying to balance expenses, debt payments, and savings. At the same time, according to the IRS, the average refund in 2009 (for tax year 2008) was just under $2,700. Or roughly $225 per month. Now that doesn’t seem like a big number, but would receiving an extra $225 per month in cash be helpful?
At the same time, since they pay down to zero, it is safe to assume that during the year they carry a balance on their cards that build up to around $2,700. Assuming a 19% interest rate on the card, the interest adds up to around $270, or another $23 per month. The actual required payment would have been higher.
Plus, if this couple instead had saved the money on a monthly basis instead of having the IRS hold it, the interest would have been another $58 at an assumed 4%. And don’t forget I’m not even adding in the opportunity cost of interest potentially earned on the interest paid on the balance.
Factor in also the fact that if this family needed to access the money during the year, they couldn’t. The IRS doesn’t hand out mid-year partial refunds. Now, they used their credit cards instead, but given what’s happened in the past two years, is that really wisest move? What if their credit card companies decided to lower their limits as many companies have in the past year? Where would the money come from then?
This is a common financial move that families make. And those families might say that money isn’t necessarily tight, but not much is left at the end of each month. This one simple example shows how people can easily free up money each month without impacting lifestyle.
Over the long term, that interest savings (from not carrying debt) and interest earned can really add up.
Answer to the last trivia question: A – The average credit card debt was $7,800 and card companies earned over $20 billion in penalty fees (late charges, overage fees, etc.).
This week’s trivia question: According to the College Board, the average tuition for an in-state public university was $15,213 for 2009/2010, rising 6.2% per year over the last 20 years. If instead tuition had only risen at the same rate as CPI (the standard measure for inflation), what would tuition be instead?
A - $5,654
B - $7,889
C - $10,728
D - $12,957
