Should I Pay Down Debt with my Tax Refund?

Ask Natalie: Should I Use My Tax Refund to Pay Down Debt?

Dear Natalie. The IRS is sending out stimulus checks to all taxpayers, plus I’m getting another $5,000 back in my tax refund. Should I pay down the debt on my credit cards, take a vacation or invest the money? My wife and I can’t agree. Help! Signed: Vacation Happy

Dear Vacation Happy: If you’ve ever played my Billionaire Game, then you know that I believe there is a divine flow of money that, when followed, leads to the rich life. The Billionaire Game takes you through the process of how you would spend that money if you had all the money in the world. When you apply that logic and those disciplines to your current situation, then the right answer for your and your wife becomes VERY clear! So, take the time to play the Billionaire Game with your wife to help resolve this. You can get the details of the Billionaire Game in the volume 5, issue 3 NataliePace.com ezine.

According to an Associated Press-AOL Money & Finance poll released on April 10, 2008, the majority of Americans are spending their refunds this year to pay bills and to pay down debt. As a point of policy, I don’t think that is a good idea, for a number of reasons. In the natural world, what you focus on expands. If you focus on debt or if you’re stuck in the rut of basic needs and survival, you never get out of it largely because you haven’t changed the habits that got you into debt in the first place. If you focus on wealth creation strategies, then you step into a healthy relationship with money that allows you to earn more and spend less in a more balanced way, while eliminating your debt and making sure it never builds up to an albatross again.

Let’s say that $5,000 refund was a $1,000,000 inheritance that you just received. If you thought about paying down $100,000 debt first, then you wipe 1/10 of your money out of the inheritance and bring the principle down to $900,000. If you invested the money, then your debt could be paid with the returns, as average returns on $1,000,000 are 10% annually, or $100,000 per year. In that scenario, your debt could be paid off in one year, and you preserve all of your principle. The following year, you should have $100,000 income (that 10% return) to enrich your lifestyle.

Put your debt on a payment plan that is consistent with the 50% to survive and 50% to thrive "Buy My Own Island" plan that is outlined in the Billionaire Game. (Debt repayment is part of your survival, incidentally, not your thriving.) The reality is that when you get your debt on a payment plan, get your spending in line with the Thrive budget and focus on increasing your monthly income through your job as well as your investments, you are embracing a strategy that works. When you try to decrease debt simply by making a lump sum payment, the odds that you build it up again are extremely high, because your income hasn’t increased, your spending hasn’t decreased, your investments haven’t flourished and your skill level hasn’t improved. In order to become wealthier than you are today, all of those things should be addressed – more income, more education, more skills, better investing habits and a lower monthly nut!

As an example of how this works, there was a woman we’ll call Wendy. Wendy had put about $30,000 on credit cards when she was launching her business in 2003. Her business wasn’t doing so well, so by 2005, she was barely paying the minimum payment each month. As a result, the penalties and interest had doubled her debt to almost $60,000. Wendy called the credit card company, told them her dire situation and started a monthly payment plan of a minimum amount that she could afford at the time. In 2008, Wendy was contacted by the debt collector at the credit card company and asked if she was interested in setting up a repay plan that was more acceptable to the company.

The debt collector was initially aggressive about the principal and need for a high payment, which was much higher than anything Wendy could really afford. When the collector said, "But your debt is almost $60,000!" Wendy responded by pointing out that half of the debt was penalties and interest. She also noted that she’d been faithful about making payments on the debt, even though her business had been struggling.

As a result of religiously paying the minimum payment over the last three years and pointing out to the debt collector that original amount owed was only $30,000, Wendy was able negotiate a new principal of $45,000 and monthly payments to pay off the debt, which were well within her ability to repay. If Wendy continues to make her payments on time, there will be no further penalties or interest on the account.

With that out of the way, Wendy focused on getting a book deal to promote her business, on getting her business cash positive and partnering with some big partners in achieving her goal. That focus resulted in a lot more income to her. More income means that she has the ability to make bigger monthly payments on the debt going forward, and potentially even under better terms. On the other hand, if Wendy’s focus had been solely on paying down debt, instead of on business expansion as well, she might have made a slightly larger payment, but nothing close to the $15,000 of the debt, which was written off. And who knows if she would have gotten into a position of earning more income so quickly!

Debt is similar to dieting. When you adopt healthy eating habits, you’re more likely to lose weight and never gain it back. When you "diet," you’re more likely to yo-yo between weight loss and weight gain. When you adopt healthy fiscal habits, you’re more likely to create wealth. When you try to pay down debt in one lump sum, you’re more likely to balloon back up to serious debt fairly quickly, which keeps you too sad, depressed and at wit’s end to focus on wealth generating strategies and investments!

In short, the good news, Vacation Happy, is that a healthy approach to money includes fun, so you get to have your vacation, your investments and to pay down debt, too! If you really want to get into the flow of prosperity, that $5,000 plus refund should also include two items that were not on your list – charity and education. There is no reason to stay trapped in yo-yo debt dieting, when you can adopt the habits of the very wealthy and start living a richer life right here and now.

Be sure to share where you go, what you invest in and the fantastic results of your own debt repayment negotiations at my AskNatalie blog at http://asknataliepace.blogspot.com/!