Many families rely on their tax refunds to pay for major expenses and essentials, but a new law will delay refunds for 3 million households for up to a month this year.
For people who need that money to pay for medical expenses or necessary car repairs, that’s a huge problem. Many will take out a tax refund loan to fill the gap.
But going that route can be costly and even dangerous. Below, find out how tax refund loans work, why you should avoid them, and what you can do instead.
What is a tax refund loan?
A tax refund loan, sometimes called a tax loan or refund anticipation loan, is a short-term loan offered by third party companies to consumers. Many companies offer on-the-spot cash, with the expectation that once the IRS processes your tax return and sends out your refund, you can pay it back.
Tax refund loans used to be offered primarily by shady companies that opened overnight and preyed on poor neighborhoods. But in recent years, big-name tax preparers have gotten in on the idea, too.
For example, H&R Block announced that they would begin offering a program called Refund Advance. Under this new initiative, consumers can get a loan up to $1,250 in value on a prepaid MasterCard. To repay this, the loan amount is deducted directly from your refund after it’s processed.
Jackson Hewitt offers a similar program, where consumers can get a loan up to $1,300.
While some companies do not charge interest or fees, other tax preparers do charge substantial fees to give out loans — and the interest rates can be astronomical.
Why you should reconsider a tax refund loan
Tax refund loans sound like a great idea in theory; families in desperate need of a windfall can get a least some of their refund on the spot while they wait for the IRS to process their return.
But as the saying goes, if it sounds too good to be true, it probably is. Here’s how tax refund loans could get you in trouble.
1. Losing part of your refund
Sacha Ferrandi is the founder of Source Capital Funding, a finance company in Minnesota, California, and Arizona. Ferrandi urges individuals be very cautious before considering a tax refund loan.
“One of the major drawbacks of a tax refund loan is that you are essentially paying to receive your refund a few weeks earlier than planned,” says Ferrandi.
“Sometimes you can pay as much as 10 to 20 percent of the total refund amount, and if you are not careful with your repayment schedule, you may even end up spending upwards of 60 percent of your refund on the cost of the loan.”
Ferrandi advises people to only go this route in an absolute emergency, such as a much-needed medical procedure. Otherwise, it’s worth it to wait for your refund, so you get 100 percent of what the IRS owes you.
2. Impact on credit score
Reputable companies that offer tax loans without high fees or interest rates have some drawbacks, as well. Like a traditional loan, consumers have to apply for a tax refund loan and the lender has to approve them.
“Another major drawback of a tax refund loan is the potential to significantly lower your credit score,” says Ferrandi. “If you miss a single payment on these loans, your credit score will ultimately be impacted negatively, and this will hurt you in the long run.”
And if you miss a payment, there can be even more severe consequences.
“There are some lenders that do not care about the individual, and if you miss a payment for any reason, they will still try their hardest to recoup their investment,” says Ferrandi. “This may mean turning you over to collections.”
3. Incorrect returns
The tax loan you are approved for is dependent on the total refund you are eligible for from the IRS. But that number is dependent on how well your tax professional did his job. If he made a mistake and determined that you would get a larger refund that you should really get, a tax refund loan can compound a serious problem.
Not only will you owe the company the loan, but if the refund calculation was wrong, you could owe the IRS, too. You might end up owing far more money that you should have ever had to pay.
What you can do instead
Instead of applying for a tax refund loan, it makes financial sense to file your return electronically to get 100 percent of your refund. If you use free tax filing services, such as MyFreeTaxes or VITA tax preparation sites, you can file your return online and get your entire refund in your bank account in as little as one week.
Even when accounting for IRS delays, if there is any way you can make it a few weeks without a refund, it’s worth waiting for the IRS to send it out.
For more information about filing your taxes and what to look out for, check out this article on four common tax scams.