Should You Use a Tax Refund to Pay Down Your Principal? It Depends
It’s a time of the year many Americans dread: tax season. While preparing taxes can be painful work, almost 80% of those in the U.S. will get a refund, with an average of about $2800 over the past few years. But if you find yourself with a nice chunk of change after filing taxes, what should you do with it? For many, it might seem obvious to put a lump sum toward paying down a mortgage principal, but it’s important to look at the big financial picture to figure out the right decision for you and your family. Here, we outline some options to consider so you’re ready when that tax refund hits your bank account.
Option 1: Paying Down Your Mortgage
Those that opt to use a tax refund to pay down a mortgage can either pay on the principal or pay to have their loan refinanced. By putting a tax refund towards a principal, the homeowner can dramatically reduce the amount on interest paid out over the life of the loan, and build up equity in the home more quickly. Homeowners that decide to go this route should make sure that their payment goes to the principal and is not used as an early payment. Depending on the individual’s mortgage, there may be prepayment penalties—if this is the case, there may be better ways to save money in the long term, including refinancing to lower monthly payments and interest rates.
Option 2: Build Up an Emergency Fund
When times are good, it’s easy to forget about an emergency savings fund. Then the roof needs to be repaired, or the car breaks down, and the cost can devastate a bank account—or even lead to debt. Those without an emergency fund might consider starting a savings account with their tax refund to avoid any potential financial difficulty that might arise. Financial advisors typically recommend having three months’ salary in a “rainy day” fund for unforeseen situations. A cushion like this will help a family stay out of debt—and continue to pay their mortgage—should a money emergency occur.
Option 3: Pay Off Debt
Paying off a credit card, student loan, or car loan—especially those with high interest rates— could be a smart option for those hoping to pay off their mortgage payments faster. The average household with credit card debt owes about $15,500 and many adults are still saddled with tens of thousands of dollars in student loans. Paying some of these debts off can save lots of money that would otherwise be lost to interest, and free up money that can then be paid towards the mortgage principal.
Option 4: Add to the Retirement Fund
For some, the best decision may be to max out their retirement fund. Contributing to an employer match program or an IRA may provide more bang for your buck in the long run, especially if it means you can retire early and still comfortably make your monthly mortgage payments. Those without a retirement plan could use this money to make a substantial start in investing in their future.
Whether you’re hoping to refinance or planning your next house purchase, Open Mortgage is here during tax season and beyond. Contact us today.