Earlier this week, I received the following e-mail from a reader:
I’ve really enjoyed reading your site and learning more about paying down debt and how to do so. As a first-time homebuyer in 2008, I received a $7,500 tax refund this year. The deal is that the government will take $500 out of my tax refund every year for the next 15 years until it’s paid off. Additionally, if I move before 15 years, I have to pay off whatever is left immediately. (Not too worried about this, for various reasons.)
Anyway, I took the money. So, should I pay off debt with the money? Or should I just put the money in savings for emergencies? Or should I put it aside in case I move in 5 years? I’m just not sure what is the most financially-responsible thing to do. Perhaps you could address this in a post, as I know there are probably many other people in a similar situation.
It’s a great question and I think the answer depends a lot on your situation. So I’ve listed the places the money could go in order by the priority I think (personal opinion) they should have, along with comments about each one.
This is the first place to look. How much money do you have in your emergency fund? Conventional wisdom says you should save a very minimum of $1000. 3-6 months of living expenses are recommended as ideal.
If your emergency fund is looking weak, then you definitely want to start here. If you’re not sure how much to have put aside, this Bankrate calculator can help you figure out the minimum. Having an emergency fund in place helps bolster debt-repayment, because you’re not worried about holding onto that money in case of emergencies. Plus, if you do move you’ll have an emergency fund that can help you cover the tax credit repayment (barring any other major emergencies in the meantime–hopefully you’ll replenish afterward anyway).
Pay Down Debt
If you’re working on paying off debt, then using this money would save you from paying interest. That’s a plus which has to be balanced with the possibility of having to pay part of the $7500 back at some point. If you think you can knock out most of your debt (or at least your high-interest debt, not talking about mortgage here) besides the mortgage within the 5 years you’re sure you’ll be there, then it would probably be a good choice.
Once your debt is paid off, start saving up a “we may have to pay back that tax credit sooner” fund.
If it’ll take longer than 5 years to get rid of your major debt, then consider applying it to whichever high-interest debts you can knock out over 5 years and evaluate the possibility of moving again near the end of those 5 years. If at that point you can foresee moving within a couple years, then it might be time to start saving up a repayment fund.
If all you’ve got is a mortgage and a car loan (at a reasonable rate) then I’d consider putting some of it–perhaps $2500 (5 years worth of tax credits)–towards the car and putting the rest aside.
Put it Aside
This is the most conservative option–more so than the emergency fund simply because the money is designated for potentially paying back the tax credit.
If you take this option, you may want to put it in an interest-earning vehicle, such as an FDIC-insured CD (here’s how to do a CD ladder). While CDs have early withdrawal penalties, they’re usually 3 month’s interest (which is only bad if you haven’t yet earned it all). That shouldn’t be an issue in your case because you’d know when renewing whether you’d be likely to sell and have to repay the credit within that 3-month window.
If you follow this option, then take out $500 every year and apply it to your financial goals–paying off debt, saving, investing, etc. After all, you’ll have to worry about paying back $500 less each year, so why not use it?
Why Save It If You’re Building Equity That Could Pay It Off?
As I was writing this last section, I imagined someone asking “Why save it up if you’re going to be building equity in the home?” And that’s a good question. By the time you sell the house, you’ll hopefully have some equity built up and take that money with you. So you’ll have cash on hand to repay whatever is left.
I’m not suggesting you choose this as the obvious solution because these last 2 years have taught us that you can’t tell where your house’s price will go. It’s very possible that it could jump in 5-10 years and you’d have plenty of money from the sale to pay it back. But it’s also possible that it could go down.
And even if stays the same, it’s important to remember that (especially if you have a 30-year mortgage) only part of your monthly payment is going to the home’s equity anyway. Depending on how your payment schedule is set up and your type of mortgage, it may be more or less.
In sum, it’s not a bad thought but it’s not something that one could depend on either.
The Right Answer
Frankly, there is no one right answer. A lot of it depends on your financial situation—whether you have high-interest debt that’s costing you money in interest, whether you have an emergency fund, whether you have a stable job, whether you have savings, etc. And then there’s also your risk-tolerance. If you’re not comfortable using the money until you’re sure you won’t have to pay it back, there’s nothing wrong with that. Just put it aside and let it earn a little interest and use it as you no longer need to have it for backup. Or split your money between all three options–bolster the e-fund, apply some towards debt, and set the rest aside.
I hope that my thoughts on each possibility are helpful in figuring out what to do with the money. If you’re still unsure, you may want to consult a financial professional (which I am not).
So congrats on buying your first home and good luck!