My tax debt interest is adding up. Should I pay it off with a loan?

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The Credible Money Coach offers insight to help reader weigh the benefits of a personal loan to pay off tax debt. (Credible)

Dear Credible Money Coach,

I owe the IRS $16,000, interest added daily. Should I take out a loan with interest? — Mamie

Hello Mamie, and thanks for your question. Many Americans feel stressed when tax season rolls around. But if you have tax debt, that anxiety can stretch out for the entire year.

Your question highlights the biggest problem with tax debt — interest. When you owe taxes, you can also face penalties, but interest is what makes your debt continue to grow. And interest will keep accruing until you pay off the debt. Tax debt can be so burdensome that the IRS actually recommends taxpayers either liquidate assets to pay their debt, or consider getting a loan, because both options may be cheaper in the long run than paying IRS penalties and interest.

Before you take out a personal loan for any reason, it’s a good idea to compare rates from multiple lenders. Credible makes it easy to see your prequalified personal loan rates.

How tax debt works

Whether it’s through payroll withholding or estimated tax payments, the IRS expects you to pay at least 90% of the tax you owe in the months leading up to the tax filing and payment deadline, and any remaining balance by the deadline itself.

If you fall short of that 90%, you could face an underpayment penalty on top of your remaining balance, although there are some exceptions. And, if you make the mistake of not filing a return on time, in addition to not paying your full tax obligation, you can also face a failure to file penalty.

How tax debt can grow

Any tax balance that you don’t pay in full by Tax Day is subject to 3% interest which, as you noted in your question, compounds daily. Interest applies to the total unpaid balance, including the amount of tax owed, any penalties, and any unpaid interest.

While 3% may not seem like a lot, the daily compounding can cause your debt to balloon. For example, a tax bill (principal, penalties, and interest) of $5,000 can grow to $5,152 by the end of the first 12 months if it goes unpaid.

Options for paying off tax debt

When it comes to paying off tax debt, you have a few options:

Cash payment

If you have savings to cover that $16,000 balance and dipping into those funds won’t leave you financially strapped, paying off your balance in full right away is the way to go. The disadvantage of this option are that you’ll take a sizable bite out of your savings.

IRS payment plan

IRS payment plans are an option if you want to spread out your tax debt into manageable payments. The IRS allows taxpayers to do short-term and long-term payment plans, and requesting one is fairly easy. You can call 800-829-1040 or request a payment plan online.

But IRS payment plans have drawbacks, including interest and fees for setting up or making changes to your plan. If you take a long-term plan, repaying your full debt could take a long time, and interest will continue to accrue until you pay your balance off.

Credit

While using credit to pay your tax bill is literally swapping one type of debt for another, in some situations this can make sense.

If you have a credit card with a big available balance, using it to pay your tax bill might be the fastest option. But it’s rarely the best, since credit card interest rates can be high. At the end of 2021, the average rate on credit cards that were assessed interest was 17.13%, according to Federal Reserve data.

Depending on your credit score, your rate could be much higher than average. Also, since credit cards are revolving credit, your interest rate and costs may increase while you’re paying on the debt, with no definitive end date in sight.

By contrast, personal loan interest rates tend to be lower than credit card rates, so if you need to use credit to pay your tax debt, a personal loan can be a less costly option. At the end of 2021, the average rate for a 24-month personal loan was 9.39%, according to the Federal Reserve. Because personal loans are installment loans, you’ll have a definite payoff date and will know before signing on the dotted line exactly how much interest you’ll pay over the life of the loan.

But personal loans can come with disadvantages. Some lenders charge origination or application fees for processing the loan, and prepayment penalties if you pay off the loan early, so it’s important to fully understand the terms of any loan you’re considering.

Is a personal loan the best option to pay off tax debt?

Mamie, if your credit is good to excellent and you meet income requirements, you may be able to qualify for a $16,000 personal loan at a favorable interest rate and terms. A personal loan could allow you to pay off your tax debt and avoid the snowballing interest costs that can come with unpaid tax debt, credit cards, or an IRS installment plan.

Finally, don’t underestimate the mental health benefits you may realize from paying off your tax debt. Some forms of debt can be more stressful than others, and tax debt — with its potential to lead to garnished wages, property liens, and seized assets — is definitely a stressful type of debt. You may rest easier knowing you owe a personal loan lender, rather than Uncle Sam, and that your interest costs won’t continue to pile up as you pay off the debt.

You can check your prequalified personal loan rates in minutes, without affecting your credit, when you use Credible.

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About the author: Dan Roccato is a clinical professor of finance at University of San Diego School of Business, Credible Money Coach personal finance expert, a published author, and entrepreneur. He held leadership roles with Merrill Lynch and Morgan Stanley. He’s a noted expert in personal finance, global securities services and corporate stock options. You can find him on LinkedIn.