Can you use a tax refund to improve your credit?

Credit and taxes. Two things people love to think about.

Look, for a lot of people, a tax refund is the single largest lump sum of money they'll get all year. And if you're serious about improving your credit, having some cash to work with can make a real difference.

You can pay down credit card balances, catch up on late payments, or even negotiate a settlement on an old collection. Things that are a lot harder to do when you're living paycheck to paycheck.

But there's a strategy to how you use that money. And depending on your situation, the best move for your credit score might not be the same as the best move for your wallet.

Should you save your tax refund or pay off credit card debt?

This is where I think the advice gets interesting.

You've probably heard that everyone should have three to six months of living expenses saved. That's a good goal. But for someone living paycheck to paycheck, it can also feel completely unrealistic.

So start smaller. Maybe it's $500. Then $1,000. Then $2,000.

Think about the kinds of things that tend to throw your finances off. Your car breaks down. Something in your house needs to be fixed. You get an unexpected bill.

When you don't have money to cover those things, what happens? You put it on a credit card. Or you skip paying something else. And eventually, those decisions can start showing up on your credit report.

An emergency cushion helps break that cycle.

But what if you're also carrying expensive credit card debt?

Let's say your savings account is earning a couple percent in interest, but your credit card is charging you 30%. You're paying a lot of money every month just to carry that balance.

And if that card is close to maxed out, it's hurting you in two ways: it's costing you money, and the high balance can hurt your credit score.

So there's a strong argument for using some of your refund to pay that card down rather than putting every dollar into savings.

Here's something else to consider: when you pay down an open credit card, you generally free up credit you can use again. That's different from paying off a loan or settling a collection, where the money you pay isn't available to borrow again automatically.

Now, I wouldn't treat that available credit as exactly the same thing as emergency savings. A card issuer can lower your credit limit, and there are plenty of emergencies where you need cash.

That's why I'd try to do both, if you can: keep some cash available for emergencies and put some money toward those high-interest balances.

The goal is to get yourself into a better financial position, not just chase a higher score.

Which credit card should you pay off first?

My approach is pretty straightforward: start with the card charging you the highest interest rate. Then move to the next highest, and so on.

Why? Because you're saving yourself the most money in interest over time.

Let's say you have three credit cards, and one is charging you close to 30% interest. That's expensive debt. Every month you carry that balance, more of your money goes toward interest instead of actually reducing what you owe.

I'd want to get that under control.

Now, there's another school of thought that says you should spread your payments across cards to get each one below a certain percentage of its limit.

And there are situations where that makes sense, particularly if you're getting ready to apply for a mortgage, a car loan, or another type of credit.

But if you're not applying for credit anytime soon, I'd generally focus on saving interest.

One important thing: Keep making at least the minimum payment on every card, on time, even while you're putting extra money toward one of them.

Missing a payment can create a bigger problem than the one you're trying to solve.

Will paying down credit cards improve your credit score?

It certainly can.

One of the things credit scoring models look at is how much of your available revolving credit you're using. That's called credit utilization.

If you have a card with a $5,000 limit and you're carrying a $4,500 balance, you're using 90% of your available credit on that card. That's a lot.

Paying that balance down can help your score because you're no longer using such a large share of your available credit.

Credit card companies typically report updated balances to the credit bureaus monthly, so you may see the change reflected in your score within a month or two.

And here's something people sometimes get wrong: You do not need to carry a balance or pay interest to build good credit.

If you can pay your statement balance in full each month, that's generally the better move. It keeps your utilization manageable and typically lets you avoid purchase interest.

If you want to understand that piece better, read How credit utilization works and How to use your credit card the right way.

What if you're already behind on payments?

Before you start making extra payments on credit cards, take a look at anything that's overdue or about to become overdue.

Because here's the thing: paying down a balance is great, but you don't want to do that at the expense of letting another account go late.

Many creditors report missed payments once they're 30 days past due. If you continue falling behind, that can turn into a 60-day or 90-day delinquency.

And those late payments can stay on your credit report for years.

So if you can use your refund to get an account current or keep a payment from becoming 30 days late, that may be the better move.

I'd also pay attention to any debt that's about to be sent to collections. If you can resolve it with the original creditor before a collection account gets reported, you may be able to avoid additional damage to your credit.

Getting current won't erase an accurate late payment that's already on your report. But it can stop the delinquency from getting worse.

The goal from there is simple: get current and stay current.

Should you use your tax refund to pay off collections?

Potentially, yes. And this is one of the places where having a lump sum can really work in your favor.

Let's say you owe $2,000 on a collection account.

If you're making just enough to cover your monthly expenses, you probably don't have much room to negotiate. You might be able to offer a small monthly payment, but that's about it.

Now imagine you have a tax refund and can offer a collector a lump sum to settle the account.

That changes the conversation.

In my experience, having the ability to pay an agreed settlement amount all at once can give you more negotiating power. Some collectors will accept less than the full amount owed to resolve a debt.

That doesn't mean every collector will negotiate or that you'll always get a great deal. But having cash gives you options.

Will paying off a collection improve your credit score?

Not necessarily.

This is an important distinction, because resolving debt and improving your credit score aren't always the same thing.

Paying or settling a collection generally doesn't automatically remove it from your credit report. And whether it helps your score depends on the scoring model.

For example, FICO Score 9 ignores paid collection accounts when calculating your score. FICO Score 8, which is still widely used, generally does not.

So I'd approach a collection settlement as a way to resolve an outstanding obligation, not as a guaranteed way to raise your score.

Before you pay an old collection, though, do your homework.

Depending on your state's laws, making a payment or acknowledging an old debt can sometimes restart the time period during which a collector can sue you.

And if you negotiate a settlement, get the terms in writing before you pay. You want documentation that the agreed payment will settle the debt.

You also don't necessarily need to hire a debt settlement company to negotiate for you. Those companies can charge substantial fees and may encourage people to stop paying their bills, which can create even more credit problems.

For more on this, see How collections work and Does medical debt affect your credit score?.

How much of your tax refund should you spend on yourself?

Look, the obvious financial advice is: don't buy the thing you want. Put every dollar toward debt. Be responsible.

And sure, if you're behind on rent or you can't cover your bills, that's where your money needs to go.

But I don't think that's the whole answer for everybody.

For most of my life, my family has struggled financially and I've lived paycheck to paycheck. I know how hard these trade-offs can be.

Sometimes there's something you've wanted for a long time. Maybe it's a new phone. Maybe it's a dirt bike. Whatever it is.

You've got to live.

So maybe you think about your refund as an 80/20 or 90/10 split.

Put 80 to 90% toward getting yourself into a better financial position: building savings, paying down debt, catching up on bills.

And if you can afford it, take 10 to 20% and do something for yourself.

It's not a hard-and-fast rule. If you're facing urgent expenses, those come first.

But improving your finances is a long-term process. I think it's okay to enjoy a little of the money you're working so hard for.

Just be reasonable about it.

Does the same advice apply to a bonus or other windfall?

Absolutely. The same basic principles apply.

A windfall is just money you receive outside your normal income. It might be a tax refund, a bonus from work, or an inheritance.

Whenever you get a lump sum of money, you have an opportunity to do something with it that might be harder to accomplish through your regular monthly budget.

My advice is to make a plan before you spend it.

Figure out what needs immediate attention. Make sure you have some emergency savings. Look at your high-interest debt and anything else affecting your credit.

And then decide how much, if anything, you can comfortably spend on yourself.

If you don't have credit card debt or collections, great. Maybe your best move is to build up your savings or work on establishing positive credit history. That's where How to build credit from scratch can help.

The important thing is to make the money work for you.

Common questions

Read next

How to build credit from scratch (when you have no credit history)