April 18th is fast approaching, which means you have only a few remaining weeks to deal with your 2016 tax returns. And while the topics of taxes and credit reporting don’t normally find their way into the same sentence, they do have considerable overlap. Specifically, if you don’t pay your taxes or you’re fortunate enough to get a refund back on your state or federal taxes, then your credit reports and credit scores may become very relevant to the conversation.
If you don’t pay your tax obligation, then there’s a chance your state or the Internal Revenue Service will file a tax lien in your name. Tax liens traditionally find their way onto consumer credit reports. And although the future of inclusion of tax liens on consumer credit reports is in question, for the time being they are commonly reported to the three national credit reporting companies (Equifax, Experian and TransUnion), and most credit scoring models, including the VantageScore models, treat them as serious derogatory entries, with the potential to lower credit scores considerably.
If you overpaid your taxes during the previous tax year, then you are likely entitled to a refund of some amount. What are you going to do with this unexpected cash infusion? I can tell you what you should do with it: Pay off some of your debt.
Aside from missed payments on your obligations, your outstanding debt—and specifically your credit card debt—is the second-most influential factor in your credit scores. There are several credit scoring metrics that analyze some aspect of your credit card debt, and all of them can lead to lower scores if you’re not performing well.
One of the most overlooked factors in your credit scores is the number of accounts on your credit reports that have a balance greater than zero. Many people believe that just because you’re making your payments on time that you’ll have fantastic scores. This is certainly a great start, but it’s not the only factor that will lead to a great score. If you have several accounts with outstanding balances, then your scores will not be as high as they would be if you had fewer accounts with balances.
If you can use your tax refund to pay off accounts with outstanding balances then your scores will likely improve. This doesn’t mean paying off your mortgage or your car loan, because that’s not realistic. But to the extent you have retail store credit cards, gas credit cards or even general-use credit cards with small balances, you should definitively eliminate them.
Even if you are unable to pay off one or multiple credit card accounts, that doesn’t mean your tax refund can’t be used to improve your credit scores, and perhaps to a significant extent. If you have a credit card that has a balance that’s very close to the credit limit, then your scores are suffering.
This relationship between outstanding balance and credit limit is called the “debt-to-limit” ratio. It’s calculated by dividing the balance by the limit and then multiplying that figure by 100. So if you have a $5,000 balance on a card with a $10,000 limit then your debt-to-limit ratio is 50 percent. That’s better than 60 percent, but not as good as 40 percent—or 30 percent, the level VantageScore Solutions generally recommends you should stay below if you want the best-possible credit scores.
Credit-scoring models typically consider the debt-to-limit ratio for each of your credit card accounts, as well as the total debt-to-limit ratio for all of your cards combined. To calculate the total figure, add up all the credit limits for your cards and all the outstanding balances. As with each individual card, divide the total of your balances by the total of your limits, and then multiply that figure by 100.
You certainly don’t have to pay off your entire credit card balance in order to improve your credit scores. If you can use your tax refund to reduce your outstanding balance from $5,000 to, perhaps, $3,000, then you’ll have reduced the ratio to 30 percent, which is much better than a ratio of 50 percent. And if you can reduce the level even more, perhaps close to 10 percent, then your scores may improve considerably. Add to that the fact that you won’t be paying interest on the credit card debt and it doesn’t take a financial genius to see the substantial benefit of using your tax-refund dollars wisely.