Tax Return Question

Here is a question that came in from a Bank On Participant related to best use of a tax refund:

With our tax return my wife and I have figured two options: the first would be to put the majority of it towards our largest debt, bringing the interest charges down. The second would be to pay off 2 or 3 smaller debts then using the money allotted to those monthly payments towards the larger debt and a savings account.

Is there a clear choice in the situation, or are we missing something? Thanks for your advice.  - GB


Dear GB:
Related to your question:  Smart thinking to use the refund to pay down debt.  I have no idea how large your refund is, but here are some rules of thumb that might be a help to you.  

Idea #1:  When paying off debt, if you do not have an emergency fund in place you will have a hard time breaking the debt cycle.  Murphy's law says that if anything can go wrong it will.  We all know unexpected expenses crop up just when you least expect it. 

Start by having at least $200 - 300 in a savings account and then work up to having at least one month worth of expenses.  If you have $300 in savings, you will create a small buffer for the unexpected and you won't have to go back to your credit cards if something should happen; you can borrow from yourself instead of the credit card and repay without all the interest charges.

My favorite strategy is to pay myself interest if I ever need to go to my emergency fund.  The bigger penalty I charge myself, the less tempted I am to use it for non-emergencies.  Also, it helps me to grow my emergency fund faster by adding the penalty to the amount I already had saved.

Idea #2:   There is great discussion in the financial community about best strategy for starting debt reduction.  The math guys say attack the highest interest rate debt because that will reduce your overall interest payments the fastest.  The problem is if your highest interest rate is on the largest debt, you may lose enthusiasm for your debt reduction plan before you pay off the first debt.

Studies indicate that attacking the smallest debt first and then the next gives you the quick successes in paying off debt that help you keep the momentum going.  There is a great website to help you build a debt reduction plan called PowerPay.  It is free from Extension Services.  You create your own login and can see how soon you can get out of debt.  As you make payments, you can see your progress toward being debt free!  You can visit the website at www.powerpay.org  Once you complete your debt reduction you can move right into power saving for your future needs!

Hope this helps and keep the questions coming!