How to Spend Your Tax Refund on a Car

During tax season, you might hear advertisements from car dealerships urging you to bring in your refund check to buy a new car. The ad strategy may be working: A third of all Americans spend their refund on an auto-related purchase, according to one survey.

The average federal tax refund is about $3,000, according to the Internal Revenue Service. That's a pretty good chunk of change. So what's the best way to spend it?

First of all, keep in mind that this is not "found money." It is actually your money being returned to you. But since most people don't include a refund in their budget, the temptation is to view it as a bonus and splurge. Instead of blowing it on an extravagance, why not use it to get ahead of the game?

If you need a new car, this could be a good time to make that purchase. But you should spend your hard-earned money wisely by carefully considering the following options:

1. Use the money as a down payment on a new or used car
2. Make a large drive-off payment on a new-car lease
3. Pay down an existing car loan
4. Refinance your current loan
5. Fix or upgrade your current car

1. Use the money as down payment on a new or used car

A substantial down payment is one of the most important factors in securing an auto loan or lease. Particularly for shoppers with poor credit, using a tax return as a down payment can create finance options that otherwise may have been out of reach.

"A $3,000 down payment does a number of things to help a customer with challenged credit," said Paul Scott, a sales manager at Nissan dealership in California. "First, it shows the lender how serious the buyer is about taking on a loan. It also reduces the likelihood of the buyer being upside down during the life of the loan." But most importantly, he says, the reduction of the loan amount means a smaller payment to fit better into a buyer's budget. That makes it easier to get approved.

2. Make a large drive-off payment on a new-car lease

Normally, Edmunds recommends that you spend about $1,000 to start a new lease. However, if you start your lease with a larger down payment, the monthly payments will be a lot lower. Not only are lower payments easier to manage, but if you want to extend the lease, you may be allowed to continue to pay this lower amount on a month-to-month basis. This strategy provides you with both flexibility and affordability. If you plan to do this, however, check your contract carefully to make sure it is allowed; some leasing companies have different rules. And make sure your drive-off payment is protected by gap insurance in the event of an accident in the first few months of driving.

3. Pay down an existing car loan

Some people might consider using their tax deduction to knock down the balance on their existing loan so they are carrying less debt. There are two ways to do that: Make an extra payment or two, or pay down the balance. Making extra payments means you pay off the loan sooner. Paying off the balance will reduce the amount of interest paid over time. If you want to go either of these routes, call the lender and determine the best way to proceed.

4. Refinance your current loan

Are you an unfortunate used-car buyer who's been saddled with an 18 percent interest loan? By refinancing at a competitive rate, you could slash your monthly payments in half. If your car loan has a high interest rate, or you have improved your credit rating since you took out the loan, you could use your tax refund as an opportunity to structure a better loan. Use all or part of the refund to reduce the principal on the loan and get a better interest rate on the balance.

5. Fix or upgrade your current car

Many cars, provided they are well maintained, can be driven well past 100,000 miles these days. And in many cases, maintaining a car you own costs much less than buying or leasing a new one. With that in mind, where do you spend your upgrade money?

A new set of new tires can greatly improve ride quality, reduce road noise and even improve fuel economy. A major tune-up further boosts fuel economy, smooths out a rough idle and prolongs a vehicle's life.

Other inexpensive repairs that can go a long way to rekindling your pride of ownership include clearing foggy headlights, getting a thorough detail, and repairing interior rips and tears. New floor mats alone can improve an older car's interior appearance. Dent removal and paint touch-ups can often be done by a mobile service for just a few hundred dollars.

These fixes certainly don't replace the thrill of new car smell. They will, however, make driving your current car more enjoyable and will likely prolong its life, reducing your need to get a new car and saving you money down the road.

Final Tip: Be Prepared

If, after considering all these options, you decide to buy a new car, remember that all the rules of smart car shopping still apply. One last piece of advice: Don't simply walk on the car lot carrying your IRS refund check, ready to be signed over. This will send the wrong message to the car salesperson, signaling that you are perhaps desperate and unprepared for the car buying experience.

Instead, tuck your check in the bank and decide ahead of time whether to lease, buy new or buy used. Only by planning ahead and applying sound advice to car buying can you make the most of your refund and save money in the long run.