Ask Dimkoff: Tax Refund
Q: I will be getting an income tax refund. Do you think I should invest it, or should I use the money to pay my credit card balance?
A: Most credit cards charge interest rates ranging from 12% to 23%. Only individuals with the highest credit scores (read that as not many college students) qualify for rates near the lower end of the range.So let me assume you are paying a credit card rate near the upper end, say 20%. That’s around 80 times the interest rate you can get stashing your money in an interest paying bank account.It’s also about 2-3 times greater than the return you can average in the stock market.
Because not having to pay 20% on your credit card is equivalent to paying yourself 20%, you should use your tax refund to pay down your credit card balance.
Did you hear about the time Larry King was interviewing Satan?At one point, he asked Satan to name his proudest dirty deed.Satan waived off the question, stating that he had caused so much evil he couldn’t possibly pick a favorite.But Larry King persisted with the question.Satan was lost in thought for a moment, and then said, “I guess the worst thing I ever did would be this.Many years ago, I created credit cards.”Okay, it’s only a joke, but it has more than a grain of truth.Try not to build up a new card balance.
If you have any of your tax refund left after paying your credit card balance, use it to build up an emergency fund equal to 6 months’ worth of your unavoidable expenses.Yes, the general rule is to have 3 – 6 months set aside, but 3 months is enough only if adequate insurance coverages apply, other sources of money (such as your parents) are available, you have great job security, and so on.Accordingly, a typical college student needs 6 months.Keep your emergency fund in a bank savings account, even though the interest rate is dismally low, and resist the temptation to spend you emergency money on anything except real emergencies.
Dr. Dimkoff is a finance professor in the Seidman College of Business. He is a Certified Financial Planner and a Chartered Life Underwriter. Do you have a question for Professor Dimkoff? If so, send your question to firstname.lastname@example.org.