Are you expecting a tax refund this year? What if instead of spending the money before you even have it in hand you use it to improve your credit?
If you have poor, fair, or even average credit, your credit score could use a boost and your tax refund could be the perfect way to make it happen.
Here’s how to use your tax refund to improve your credit score.
What’s a Bad Credit Score?
A bad credit score can be subjective. It also depends on what you’re trying to accomplish with it. For example, if you’re applying for a mortgage, you’ll want a credit score of 680 or higher for the best options.
If you’re trying to get a new job or get new insurance, you might get away with a 650 or higher score.
The bottom line is that you need decent credit to do just about anything, and the better your credit score is, the easier it is to achieve your financial goals.
What Does a Tax Refund Have to Do With Your Credit Score?
Your credit score is made up of five factors, several of which your tax refund can help you improve.
Here’s what makes up your credit score:
- Payment history (35%) – This is the largest part of your credit score. One late payment can cause your credit score to drop 100 points or more in some cases. It’s vital that you have a perfect payment history if you want to have a credit score over 700.
- Credit utilization (30%) – Your credit utilization is the comparison of your outstanding credit card debt to your credit line. Ideally, you shouldn’t have over 30% of your credit line outstanding for the highest credit score. This means for every $1,000 credit line, you shouldn’t have more than $300 outstanding.
- Credit age (15%) – Your credit age plays a role in your credit score. The older your credit is, the more history the credit bureaus and lenders have to use to determine if you’re a good risk. The longer your credit history is, the higher the likelihood is that you’ll have a good credit score.
- Credit mix (10%) – Your credit mix is the number of revolving debts you have (credit cards) and installment debts (personal loan, car loan, etc.). The better the mix of credit you have, the better the idea lenders can get of how you handle your debt.
- Inquiries (10%) – Each time you apply for new credit, the lender puts an inquiry on your credit report. Too many inquiries can be a sign that you are in over your head in debt and need money fast. Lenders do, however, recognize when you’re shopping around for the best rate. If you have multiple inquiries for the same type of loan it doesn’t count against you.
5 Ways to Use Your Tax Refund to Improve Your Credit
So how can your tax refund help you improve your credit? Here are 5 ways.
1. Bring your Accounts Current
Start by using your tax refund to bring your accounts current. Pull your credit reports here and see if you have any late payments.
If you have any balances over 30 days late, pay the past due balance now. This will immediately help increase your credit score. The key is to pay your balances and bring them current. If you can’t pay them all at once, get in touch with your creditor to see what plan you can work out to get caught up.
The faster you get your payments on track and continue paying them on time, the faster your credit score will improve.
Creditors report your history every 30 days, so it can take a month or two to see improvement, but be patient, it will happen.
2. Pay Your Balances Down – Reduce Your Credit Utilization
A great way to use your tax refund is to pay down your loan balances, especially credit cards. Look at your credit utilization rate first and see which cards may be increasing your credit utilization.
You can use this strategy in several ways.
- If your refund is large enough to pay off all your debts, do it. Pay your debts off and give your credit utilization rate a fresh start. Moving forward, try to keep it at 30% or less so it doesn’t negatively affect your credit score.
- If you can only pay off some debts, figure out which cards have the highest credit utilization rate and pay them down or off first. Try to get all cards to a credit utilization rate of 30% or less.
- Use the debt snowball method. If you aren’t sure which debts to pay down, order them from smallest to largest balance and pay off the first debt in line. If your tax refund allows room for more debts, keep going down the line until you’ve paid off as many debts as possible.
3. Open a Secured Credit Card
If you don’t have good credit or you have no credit, you may not be eligible for a credit card yet. But, you can get a secured credit card in most cases.
A secured credit card requires a security deposit. Your credit line is equal to the deposit. So if you put down $500, you’d have a $500 credit line.
This can be a great way to build credit. If you use the card right (don’t max it out, pay your payments on time, and pay the full balance each month), it can help your credit score.
Most credit card companies regularly review your account and upgrade you to an unsecured credit card when they think you are ready, which means they’ll refund your security deposit too.
4. Pay for Purchases in Cash
You don’t have to use your credit cards to build credit. In fact, if you don’t have to use them, don’t.
If you have a large purchase you need to make, like appliances or furniture, consider using your tax refund to pay for them upfront. This keeps your credit utilization rate down and reduces the risk of ruining your payment history and hurting your credit.
5. Put Money in Your Emergency Fund
If you don’t have an emergency fund yet, your tax refund is a great time to start. An emergency fund should have 3 – 6 months of expenses in it to cover you should you lose your job, fall ill, or get hurt and be unable to work.
Your emergency fund should carry you through 3 to 6 months while you figure out what you can do to fix the situation, such as losing your job.
When you have an emergency fund you don’t have to worry about which bills you’re able to pay. You should be able to pay them all, reducing the risk of hurting your credit because you missed payments or had to max out your credit cards.
How Long Does It Take to Improve Your Credit Score?
Don’t expect your tax refund to fix your credit score overnight. It could take time.
It depends on what was bringing your score down. Creditors report your information monthly, so anything that changed will get reported right away.
For example, if you had late payments and you brought them current, it could help your credit score right away. As soon as lenders report that you’re on time, your credit score will increase slightly. If you keep making your payments on time, it will continue to increase your score.
If you had other issues with your credit score, such as maxed-out credit lines, too many revolving debts, or your credit age was too young, it could take time to fix it.
The key is to have patience and wait for your credit score to change. Keep up the good habits by doing the following:
- Pay your bills on time. Always pay your bills before the due date. If you miss a due date, make sure you don’t get more than 30 days behind, so it doesn’t affect your credit score.
- Keep your credit card balances down. Don’t use your credit cards as an extension of your income. If you charge anything, make sure it’s 30% or less of your credit line, or make sure you can pay the balance in full right away.
- Don’t take on too many credit cards. Keep a good credit mix of revolving and installment debts to ensure that you show financial responsibility.
- Don’t apply for credit you don’t need. Don’t apply for every ‘pre-approval’ that comes your way. Only apply for credit when you need it and when you can afford the best terms.
Using your tax refund wisely is the best way to improve your personal financial situation, especially your credit score. Use it wisely and you could put yourself in a much better position.