Tax season can be a dreadful time of year if you owe the federal or state government money. But if you're fortunate enough to get a tax refund, you may have big plans for your check. You can probably think of a million ways to spend this money. Will you take a vacation? Update your wardrobe? Or purchase the newest, baddest electronic devices?
“Free money” doesn't fall in your lap every day, so there's nothing wrong with a little splurge. But rather than blow all your cash on a good time, consider putting some of the tax money toward your mortgage.
Whether you're thinking of buying a place or you're already a homeowner, here are three excellent uses for your tax refund this year.
1. Refinance your mortgage loan
Mortgage rates are at a record low, but rates won't stay low forever. Some mortgage experts predict that rates will slightly increase in 2016, so if you haven't refinanced your mortgage and taken advantage of cheaper interest rates, now's the time to act.
Refinancing your mortgage can improve your financial picture, especially if you’re struggling to keep up with high monthly payments. Depending on your credit score, you might qualify for a lower interest rate, which is the ticket to getting a lower monthly payment. And based on the amount of equity you have in your home, there's the option of a cash-out refinance. A cash-out option lets you borrow from your equity. You can use the money to consolidate credit card debt at a lower interest rate, or use the money for home renovation projects that can raise your property value.
Refinancing a mortgage requires submitting a new application and meeting a lender’s mortgage guidelines. And unfortunately, you also have to pay closing costs such as the loan origination fee and an appraisal. Closing costs can run between 2% and 5% of the mortgage balance. Some lenders give applicants the option of including closing costs in the mortgage, but this approach increases the balance. Using a tax refund to pay closing costs means you can refinance your house without increasing the amount you owe your bank.
2. Buy a new home
Homeownership offers a sense of stability—and thankfully, you don't need a 20% down payment to purchase a home. But if you live paycheck-to-paycheck and find that it’s too difficult to save money, it can take longer than expected to drum up enough cash for a home purchase. Your tax refund can help you get the keys to a new house sooner.
Since many lenders offer low down payment options, the amount you receive back from the federal or state government could be exactly what you need to purchase a home. Let’s say you're buying a $150,000 house with an FHA mortgage and need a 3.5% down payment, or approximately $5,250. A $3,000 tax refund puts you closer to your goal. Depending on your price range and the amount you need for a down payment, you could save your tax refunds for the next two or three years and give the bank a bigger down payment. The more you put down, the lower your interest rate and the less you have to finance.
3. Make an extra mortgage payment
There's plenty of fun and exciting things you can do with a tax refund. But if you also have a goal of being debt-free as soon as possible, using your tax refund to make an extra principal payment on your mortgage can eliminate this debt years sooner.
Some borrowers choose a 30-year mortgage term to receive an affordable payment. But while a longer term reduces how much you pay on a monthly basis, you'll also pay tens of thousands of dollars in interest over the life of the loan. What you may not realize is that one extra principal payment a year can reduce your mortgage term by up to six or seven years. And if you make more than one extra principal payment a year, you can shave additional years off your mortgage term.
An extra payment not only pays off your mortgage sooner, it can help you build home equity faster and get rid of private mortgage insurance sooner. PMI is required if you purchase a home with less than 20% down. If the home forecloses, PMI protects the bank from financial loss. This insurance increases your mortgage payment, but the lender will waive private mortgage insurance once the property has 22% equity.
Put your tax refund to good use and spend the money on a purchase, refinance, or make an extra mortgage payment.