Is it wise to pay off student loan debt with my tax refund?

Millions of Americans received their tax refund and plan to use it to pay down their debt, while others will use the money to increase their savings. Depending on your financial situation, putting your tax refund towards your student loans can be one way to lower the amount you owe and save you money on interest over the life of the loan.

Making an extra payment towards your student loans is typically a good idea, but it may be a better strategy to allocate the extra money somewhere else — especially if you have federal student loans that are in forbearance until September 2021.

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Pros of paying down student loan debt with a tax refund

The most significant benefit of paying down student loan debt with a lump sum of money is that you'll save money on interest over the life of the loan and decrease the time it takes to pay it off. Plus, you may see a bump in your credit score when you pay down your student loan balance.

Before you rush to put your tax check toward your student loans, consider the type of debt you have: federal student loans or private student loans.

Federal student loans are in forbearance through September 2021, which means you do not have to make payments, and interest is not accruing. With federal loans at 0% interest, it makes them a lower priority debt, but you can still pay down the principal now. When the forbearance period ends, you'll pay less overall since the interest will be on a lower balance.

On the other hand, private student loans aren't protected by the federal moratorium. Private student loan holders still face interest charges on their loans, which means that paying off these loans can save borrowers money on interest starting now.

"If your tax return isn’t enough to cover your student loan balance, you can set funds aside to supplement monthly payments," said Leslie Tayne, a Melville, N.Y. attorney specializing in debt relief.

Private student loans also have fewer repayment options and government protections compared to federal loans, which means paying them down would be more beneficial than paying off your federal student loans.

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Cons of paying down student loan debt with a tax refund

If you're part of the Public Service Loan Forgiveness (PSLF) program, you'll want to think twice before paying off your federal student loans with your tax returns. Doing so may prevent you from meeting PSLF eligibility requirements.

But the primary drawback to using your tax check for paying off student loans is that you may be able to put that cash windfall to better use. You could save a lot more money by paying down high-interest credit card debt when compared with student loan debt.

"If you carry credit card balances, those interest rates could be higher than your student loan’s interest rates," Tayne said. "It may be a better idea to pay off those debts first, as you’d save more in fees compared to your student loan debt."

You could also consider putting your tax refund into a savings account, since this could save you from having to take out credit card debt should an emergency arise. Having extra money in a savings account can be a cushion against an unexpected bill or job loss.

"Starting a fund now could help prevent future financial stress if unexpected expenses arise or there is a partial or complete loss of income," Tayne said.

That sentiment is shared by Bruce McClary, a spokesperson for the National Foundation for Credit Counseling, a Washington, D.C.-based nonprofit.

"If you have little or nothing set aside for emergencies, you may be better off depositing your refund check to help you reach your savings goals," he said.

If you decide to put your tax refund toward debt repayment or savings, you still have options for managing your student loan debt. Another strategy is to refinance your private student loans to lower your interest rate and payments. Use an online student loan refinancing calculator to get a sense of what your new monthly payments could be.

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How to determine if you should pay off your student loans with your tax refund

Looking at your current loan interest rate and balance is a good first step to determine if it's worth it to pay off student loan debt with your tax refund check. If you have a low interest rate on your student loans, or if you have federal student loans that are in forbearance, you might be able to put the money to better use by paying down another type of debt with a higher interest rate.

"Using your tax refund to pay off your student loan will depend on how the decision impacts your personal finances," Tayne said.

Depending on the types of debt you owe, you can look into using your tax refund to pay off your credit cards and decrease your revolving credit utilization. This will also boost your credit score and loosen up some cash flow each month.

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