Tax Refund Loans: Don't Mortgage Your Future

Be careful about spending your tax refund before you get it.
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Editor's note: As a special feature for March, TheStreet.com offers an ongoing series on everything you need to know about taxes. Today is part nine.

For many Americans, tax refund day is a holiday on par with their birthday or Christmas. Some people are so anxious to receive the check from Uncle Sam that they spend it before it even arrives. However, taking on debt in anticipation of a tax return is not a decision to be made lightly.

Money Management International, a nonprofit credit counseling agency, recently published its

2007 Tax Survey results and uncovered some encouraging trends.

According to the survey, 32% of Americans plan to put their tax refund in savings. Another 46% will use the money to take care of obligations such as car repairs or outstanding debt. Others will use their returns in less noble ways. But Tanisha Warner, spokesperson for MMI, says "that's not necessarily a bad thing as long as you have a plan."

More Money Than Brains

Unfortunately, many people don't even have a plan. And they don't think about the consequences of what they do with their refund. If they did, high-cost refund-anticipatory loans (RALs) offered by tax preparers and some banks would go the way of the dinosaur.

Instead, the Consumer Federation of America says 9.6 million American taxpayers spent more than $1 billion on this costly form of credit in 2005 (the latest year for which data were available).

To understand what a rip-off these fast-cash offers can be, consider this: The CFA estimates that you could end up paying as much as $111 on a RAL for a $2,500 refund. That's an effective APR of well over 100% for a two-week advance, and it doesn't include the tax-preparation and application fees some lenders will charge.

These loans make even less sense as the IRS introduces services such as e-file and direct deposit that cut the time it takes to get a refund after filing to between nine and 16 days.

However, to counter the bad publicity surrounding refund loans, some companies have begun offering RALs at more competitive rates.

H&R Block

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, for example, has slashed the cost of these loans by 40% this year for some borrowers. A RAL on a $2,800 refund now costs a little less than $60 when deposited to an Emerald Card account.

Other kinds of borrowing decisions made with tax refunds in mind can also be questionable. Some people might enter into zero-interest or no-payment financing plans to buy expensive items such as furniture or flat-screen TVs.

They may intend to use their IRS check to pay off the balance before the promotional period ends, but what happens if the refund is smaller than expected? They could end up paying off the debt late and getting hit with big charges. Warner says it can be dangerous to "get into a situation where the money is spent before you receive it."

Strategies for Using Your Refund

MMI has developed an online forum called SaveOrSpend.com where consumers can share strategies for how to use their refund. Warner says the goal isn't to endorse any particular course of action but merely to encourage people to "give this whole process some thought before going out and getting into debt."

One man from Oklahoma visited the site to post his justification for spending his refund on a family vacation. "Our initial plans were to put it away for a rainy day." he wrote. "Well, Disney World became our 'rainy day.'"

Laura from Cypress, Texas, takes the opposite approach. She already got her refund and "put it straight into a money market account to watch it earn interest."

Others want to know why people are planning how to spend their refund, rather than preparing their tax returns more carefully to avoid paying the money in the first place. "Don't give Uncle Sam a no-interest loan," Jordan from Houston writes.

Warner says 26% of Americans intentionally overestimate their taxes as a "savings strategy." She acknowledges that the approach doesn't make economic sense when compared with the rates of return offered by savings or investment accounts.

However, she says not everyone has the discipline to keep from spending cash they have on hand. "Depending on what your situation is," Warner says, "the money could have been blown during the year."

Next in the tax series: A Look at Your Real-Estate Taxes

TheStreet.com

tax series previously featured:

  • Get Your One-Time Phone-Tax Refund
  • Don't Fear the Auditor
  • A Reason to Procrastinate
  • Booyah Breakdown: Taxes for Traders
  • Don't You Miss a Tax Credit or Deduction
  • Booyah Breakdown: Taxes for Traders
  • How to Choose the Right Tax Software
  • AMT:Little Tax Of Horrors
  • Last Chance to File for Refunds -- for 2003
  • Booyah Breakdown: Taxes for Traders II