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Taxes are not usually a happy subject, but it makes sense to take comfort where you can. Big tax refunds, often thousands of dollars, are now pouring into millions of households.
Such good fortune should not be ignored, especially if you’re in the market to buy a car, SUV, or pick-up.
The IRS had sent out refunds worth more than $245 billion as of April 19th. The typical refund was $2,850, up from $2,753 last year.
Getting a lump sum payment of nearly $3,000 from Uncle Sam is a big deal for many households. That’s because the typical household income in 2022, the latest year for which we have numbers, was $74,580 according to the Census Bureau.
The refund money has so far been distributed to more than 86 million taxpayers, and in most cases no check was involved. Instead, the money was added to checking or savings accounts electronically, so there was nothing to get lost in the mail.
A tax refund is a good thing, but how should the money be used? There’s no single answer that’s right for everyone, but in terms of the auto financing there are several major options to consider.
Buy with a bigger down payment
Auto lenders like to see loans with 20% down. That’s not realistic for many borrowers, but it can often pay to buy with as much down as is reasonable in your circumstances.
“A lender,” says Experian, “might extend better terms, such as a lower interest rate, when you make a substantial down payment.”
Progressive Insurance explains that “If your credit isn’t great, making a sizable down payment can be the difference between getting a loan approval or not. Whatever your credit score, a larger down payment on a car can result in more favorable terms — like a lower interest rate — that could save you money in the long run.”
Progressive adds that, “One rule of thumb for a down payment on a car is at least 20% of the car’s price for new cars and 10% for used — and more if you can afford it.”
The reason for the better loan terms with a big down payment is that the lender has less risk and can offer a lower interest rate.
Prepay an Existing Auto Loan
If you have a current car loan you might want to use a tax refund to reduce the balance. This, however, may not be a good choice.
If you have a loan that’s arranged like a mortgage – simple-interest financing where every payment covers the interest cost and reduces the amount owed – then reducing the balance with a lump-sum payment can be attractive.
It means the financing will be paid off quicker and the borrower will have a smaller interest cost. Speak with lenders for details.
Alternatively, if you have a so-called “precomputed” auto loan, then prepaying the loan may have less value.
“With a precomputed interest rate,” says the Consumer Financial Protection Bureau (CFPB), “the interest is added to your principal at the beginning of your loan and then split into monthly payments. This formula allocates more of your payment to interest during the first part of your loan. Making extra payments does not reduce the principal amount (or interest) owed.
“If you’re planning to pay off your loan early, a precomputed interest rate would mean you’re ultimately paying more in interest. However, you may get a refund of some ‘unearned’ interest,” it said
Pay Off an Existing Car Loan
If you have a few payments remaining on an existing auto loan it can make sense to simply pay off the balance with your tax refund. The benefits include better cash flow because you have less debt to pay each month, and a likely credit score bump because the debt has been successfully paid.
Pay Down Other Debt
It may be that tax refund money is better used for something other than auto debt.
According to the Federal Reserve, in February the typical interest rate for a 60-month car loan was 8.22% and 8.41% for 72-month financing. Personal loans were at 12.49% while credit cards were at 22.63% for those with outstanding balances.
TransUnion said that in March 2024 the typical unsecured credit balance was $11,989. It may be that other debts – especially credit cards – are better prepayment targets, especially for borrowers who do not turn around and increase debt levels once again.
A Plain Vanilla Option
A really good use for surprise money is often to stick it in a savings account or short-term certificate of deposit. Sounds boring until the moment you face auto repair costs, emergency room visits, and similar surprises.
If you don’t have cash on hand you may have to get short-term financing from payday lenders and that, says the Pew Charitable Trusts, is likely to be a costly option.
“Single-payment payday loans,” said Pew, “are unaffordable and harmful for most borrowers. The repayment periods are too short, the required payments are too large, and the annual percentage rates (APRs) are 10 times higher than traditional interest rate limits set by states. There is also evidence of numerous other problems, such as a deceptive business model; structural incentives for lenders to encourage borrowers to refinance; borrower defaults; abuse of borrower checking accounts; and weak price competition.”
There are many good things to do with tax refund money, so look carefully before spending a one-time financial bonus. Paying down car debt or borrowing less to buy can be attractive uses of tax-refund cash, but there are other options as well.