Tax refunds come as nice checks from the government in the middle of the year when you are looking for some extra cash. These funds can be used in a number of different ways. However, people are often concerned about the best way to optimize their spending. What is the best way to save money, reduce taxes for next year and get the best financing rates? This situation will be different for everyone, but there are some constants.
Paying Down Credit Card Bills or Other High Interest Loans
High interest loans like credit card debt or other forms of personal debt eat into your savings and reduce the amount you can spend on other purchases. Further, if they are not paid on time they reduce your credit rating which inhibits your ability to get a low-interest mortgage, buy a car, get a job or obtain additional credit cards.
Additionally, financial advisors often prioritize paying down credit card debt first because it is unlikely that any other investment you make will exceed the cost of the interest payments. For example, bonds are currently returning around 2%, the long run return of the stock market is 7.5% and they typical high interest credit card is about 12%. Most likely, the best financial option is to first pay down this debt and invest further income.
Mortgage Down Payment and Interest Payment
If the refund is large enough, it may be helpful in paying a down payment for a mortgage. The larger the down payment, the lower the overall interest payment will be over time. For example, say you are planning to buy a $500,000 home with a $100,000 down payment. If you have a $20,000 tax refund you may decide to place that towards the home. For a 15 year fixed mortgage at 4%, your total payments would be $532,575 without the down payment and $505,946 with the down payment. So that $20,000 can actually go further if it is placed into the home.
Lastly, if you already have a mortgage, you can use the refund to go towards the payment of those monthly bills. If there is no pre-payment penalty, you can immediately reduce the overall mortgage and reduce your future interest payments. The earlier in the mortgage the larger the impact will be on this future stream of payments. If you just have a couple years left on your mortgage, it might be best to save the tax refund for your next down payment.
You may also decide to invest in more high risk options such as stocks, commodities like gold and silver, or a small business. While it is possible or even likely to receive a high rate of return in these sectors over time, it is also extremely likely that money is lost. If you are preparing to buy a home, it is not a great idea to invest in extremely risk ventures.
For stock market investors, those preparing to purchase a home should at least consider dividend generating stocks that produce a cash flow that can be used towards the down payment or mortgage payment. Those stocks are inherently less risky as they are generating enough cash to stay solvent and distribute to shareholders. They are unlikely to decline dramatically in value or go bankrupt.
For bond market investors, the best course of action is to invest in bonds with a lot of liquidity that can be sold easily. Investors in municipal bonds may get a higher, tax free return. However, those bonds are a little more difficult to sell when they need to be turned into cash for the down payment on a home. The price is more volatile and less predictable. On the other hand, US government bonds are much easier to sell when necessary and the price does not fluctuate as much, even though the returns are lower.
***All examples presented are subject to various terms. Wyndham Capital Mortgage is not a stock market investor or broker that is licensed to provide investment advice***