Along with Christmas and the back to school season, retailers look forward to tax refund season, when Uncle Sam is dishing out tax rebate checks. They frequently time the launch of new products and services to entice you to spend your newfound wealth.
As seductive as that the new iPad looks, think before you buy. Financial experts often advise clients to first pay off interest-bearing debt like a credit card before beginning a wealth building program. Lets see why.
Meet Debbie Debtor Debbie Debtor is the average U.S. consumer carrying $3,000 in credit card debt with an annual percentage rate (APR) of 15%. Keeping the calculation simple, she accumulate $450 in interest charges by year end. You can see in this chart how the interest expense varies with your balance.
Debbie recently received her $3,000 tax refund. She is faced with a conundrum. Should she use the money to pay off her credit card, splurge, save/invest, or some combination of the three?
Pay It Off If she uses her rebate check to pay off her credit card, she saves $450 in interest expense. Result: $450 saved
Spending Spree Debbie buys an iPad, a hammock in which to relax as she uses orders food for a party she is throwing for 200 of her closest Facebook friends. Meanwhile, she maintains the $3,000 balance. Result: $450 loss
Saving/Investing With interest rates at historic lows, Debbie will earn almost nothing if she puts her money into savings or money market account. Debbie instead decides to invest in the stock market after hearing it averages 8% per year.
Assuming that the volatile stock market actually returns 8%, she will make $240. However, her debt continues to build at 15%, meaning she lost $450. Result: $210 loss ($450-$240)
Split It Debbie wants to start paying off her credit card, begin saving, and treat herself. Therefore, she decides to split the funds equally ($1,000 each) among the three options.
This results is her interest expense being $300 ($2,000 X 15%), savings $80 ($1,000 X 8%), and only being able to buy one iPad and treat two friends to dinner. Result: $220 loss (Note: There are an infinite number of splitting possibilities.)
Decision Time Only one option saves Debbie money: paying off her balance. It will eliminate her lingering debt and prevent it from snowballing out of control. When next years tax rebate comes, Debbie can choose one of the other options like saving/investing, splurging, or some combination of the two.
Learn from Debbie Use Debbies example to examine your situation. If you can use your tax rebate to pay off or down your credit card debt, do it. Then let your money work for you instead of against you. By saving and investing, you can turn the momentum of a debt snowball into a wealth snowball. Until Debbie Debtor marries Richie Rich and has confused kids, it is on her to make wise financial decisions. The same goes for you.
Tags: Refund, Tax Refund
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