With tax time around the corner, history shows the majority of Americans will likely get a refund, rather than owe the IRS money.
And while your taxes don’t directly impact your credit, how you choose to pay your bill or spend your refund can. Learn more about how you can protect — and even boost — your credit during tax season.
1. Taxes refunded: Paying down debt
If you get a tax refund, you can use that money to build good credit by paying down debt. By paying off debt, like student loans or the balance you’re carrying on a credit card, you’ll lower your credit utilization ratio, which can positively impact your credit score.
One tip as you begin to pay off debt: Prioritize the loan with the highest interest rate. You’ll reduce the overall amount of interest you pay and decrease your overall debt. Then, continue paying down debts with the next highest interest rates, and so on.
2. Taxes owed: Using a credit card or a loan to pay
If you don’t have enough money saved up to pay what you owe by check or debit card, it is possible to pay your taxes with a credit card or a personal loan. But paying your tax bill with borrowed money can impact your credit, especially if you don’t pay off your credit card or loan payment each month.
A few ways that using a credit card or personal loan can impact your finances include:
- Hard credit check. Applying for a new line of credit or a loan will prompt a hard credit inquiry. One loan or credit application will have minimal impact, but several hard inquiries can have a greater impact if you have few accounts or a short credit history.
- Higher credit utilization. If you use a credit card to pay your taxes, that will increase the percentage of credit you’re using, or the amount you owe lenders. Your amounts owed make up 30% of your credit score.
- Interest payments. If you don’t pay your credit card balance in full, you will have to pay off your tax bill plus the interest you’re incurring on your credit card.
- Debt-to-income (DTI) ratio. If you already have a large amount of outstanding debt (for instance, student loans or a car loan), taking out a personal loan will increase your DTI ratio. When you apply for credit in the future, lenders will evaluate your DTI to help determine whether you can afford to take on another payment.
- Payment history. Payment history makes up 35% of your credit score. If you pay your taxes with a credit card or personal loan, you can effectively boost your credit by paying off your credit card or loan debt on time and in full. But if you miss a payment or are late, it can hurt your credit score.
3. Taxes owed: Acquiring a tax lien on your record
If you’ve failed to pay your taxes, the IRS can issue a tax lien in order to ensure repayment. Once that tax lien appears on your credit report, your credit score could decrease by more than 100 points. In addition, a paid tax lien will remain on your credit report for seven years after payment, while unpaid liens can remain indefinitely.
If you find yourself in this situation, contact the IRS. They may be willing to work out a repayment plan to help you keep track of your payments and clear your debt.