Many Americans receive a tax refund each year. The IRS processed nearly 111.6 million returns claiming refunds in 2019, with the average refund coming in at $2,860. Getting a financial windfall, such as a tax refund, can be a great way to accelerate student loan repayment. Why? Because depending on how much you owe and how big your refund is, you could potentially shave months or even years off your student loan repayment. You’ll also reduce the amount of overall interest you’ll have to pay.
Here are some things to consider:
Before you use your tax refund to pay down student loan debt, there are a few steps you should take to ensure you’re making the most of your refund.
Make sure your emergency fund is topped up
Before you use your windfall to accelerate student loan repayment, make sure you’ve got your emergency fund in place.
It might seem as though paying off debt is more important than saving for an emergency, but an emergency fund is actually an important part of any debt repayment plan. Think about it: Without a savings net in place, what happens if you suddenly lose your job, have a medical emergency or need an expensive car repair? For many people without an emergency fund, disasters large and small can force them to rely on high-interest credit cards, which makes it even harder to get out of debt.
So before you put that tax refund toward your student loans, make sure you have an emergency fund. A common rule of thumb is to save at least three to six months’ worth of expenses, but even $1,000 could give you some peace of mind when things go wrong.
Decide which loans to target
If you have more than one student loan to pay off, it’s essential to decide which loan you should apply that extra payment to with your windfall.
There are two schools of thought when it comes to picking which debt to pay off first:
- Debt avalanche method. With the debt avalanche method, you prioritize paying off the loan with the highest interest rate first while still paying the minimum on your other loans. This strategy saves more money in the long run by cutting down the total interest you pay.
- Debt snowball method. The debt snowball method has you focus on paying off the loan with the smallest balance first, while paying the minimum on the rest and then working your way up. While it might not be the most cost-effective way to accelerate student loan repayment, it provides a quick win from paying off one of your loans in full and can help you build momentum.
Take a few minutes to decide whether to use your tax refund as a debt avalanche or debt snowball. One may help you pay off your debt quicker and save as much interest as possible. The other might provide the motivation you need to keep going with an aggressive debt repayment plan.
Make sure your extra payment is applied correctly
Have you ever tried to make more than the minimum payment on a car loan, student loan or other debt? If so, you may have noticed that your extra payment didn’t make much of a dent in your balance.
That’s because lenders apply your payment toward any outstanding fees first, then interest, before finally applying it to the loan principal. In most cases, any extra money over your required monthly payment is divided up evenly among all of your loans.
For example, imagine you have two loans with the same lender — Loan #1 for $2,000 at 7.5%, and Loan #2 for $5,000 at 4%. You want to use your $2,000 tax refund to pay off Loan #1 because the interest rate is so much higher.
But your student loan servicer doesn’t know this. So when you send in your $2,000 payment, they apply the amount evenly to your two loans — $1,000 to each — and you still end up with two loans to pay off.
You can avoid this by contacting your servicer before making an extra payment. Let them know you want to make an additional principal payment and how you want it applied. Your servicer should be able to provide instructions to ensure your payment is applied correctly.
It may seem like paying off student loan debt quickly is always a good idea. But there are some situations in which it’s not so wise to use a refund for student loan payments.
- You have other high-interest debt. If you have credit card debt, chances are the interest rate on those credit cards is higher than the interest rate on your student loans. In that case, you’re better off using your tax refund to pay off credit card debt first.
- Your loan balance may be forgiven. If you qualify for one of the several student loan forgiveness programs, you might not have to pay back the entire amount you owe. Don’t rush into accelerating your student loan payments unless you know you’ll have to pay them in full.
- You don’t have an emergency fund. We covered the importance of having an emergency fund above, but it bears repeating. If you don’t have money set aside for emergencies, prioritize saving before you pay off student loan debt.
- You have some big expenses coming up. Are you planning on returning to school, buying a house or have other significant costs on the horizon? In that case, you might want to hold on to your cash instead of putting it toward your debt. This will help ensure you’ve got those costs covered without having to turn around and take out more debt.
If you’re one of the lucky taxpayers expecting a refund this year, don’t treat it as extra spending money. Consider using your tax refund to accelerate student loan repayment so you can get out of debt faster and reduce the burden of student loan debt.
If you do decide that paying off student loan debt is your priority, we’ve got a tool to help. Use our student loan prepayment calculator to see how much you can save by applying your tax refund to your balance.