Two weeks - that's what you get for your money when you agree to sign on for a tax refund anticipation loan (RAL). What does your tax preparer get? Once the fees are tallied, this two-week loan, oh so generously offered, often works out to better than a 100% annual percentage rate in the lender's favor. And you thought the interest rate on your credit card was bad!
When you break down the numbers, it's a wonder that anyone agrees to take on a refund anticipation loan, yet in 2008, more than 8 million taxpayers took out such loans, according to the National Consumer Law Center (NCLC). In this article we'll take a hard look at these loans so that you have the information you need to decide whether they're worth the price you pay. (For insight on constructive ways to spend your refund, read Don't Waste Your Tax Refund.)
Refund anticipation loans, also known as RALs or instant refunds, are short-term loans offered on the basis of your tax refund. With an RAL, a tax preparer will offer you a payout somewhat smaller than your actual refund, but make it available immediately, so you won't have to wait for the IRS to cut you a check or deposit the money into your account. The preparer will then take the entirety of your tax refund.
If you have your taxes prepared by any of the big tax preparation services, like H&R Block (NYSE:HRB) or Jackson Hewitt (NYSE:JTX) - or even many of the smaller tax preparation services - you will probably be offered an RAL. To get the loan, you'll be asked to pay a loan origination fee in addition to your electronic filing fee. If you choose to accept such a loan, you'll receive a check immediately for the total amount of your refund, minus the loan origination fee and other fees associated with preparing both your tax return and your RAL. From the taxpayer's point of view, that's all there is to getting a tax refund anticipation loan. You don't have to pay back your loan or take care of any future paperwork. Instead, you sign a form that allows your tax preparer to receive your refund check. Then, your tax preparer cashes the check and keeps it to cover your loan.
The fees that most tax preparers charge for tax refund loans verge on predatory, much like payday and title loans. While the fees may seem small when compared to the size of the refund, an RAL can be incredibly expensive once you consider the shelf life of the loan. After all, with modern electronic filing, you can have your tax refund directly deposited into your bank account in less than two weeks. In 2006, the NCLC and the Consumer Federation of America conducted a joint study on tax refund loans. They found that a consumer will pay approximately $100 for a refund of approximately $2,150. In effect, your impatience costs you almost 5% of your return. (To learn more about another short-term, high-cost loan, read Payday Loans Don't Pay.)
Because the loan is so short-lived, the cost of the loan often outweighs its usefulness. According to a report from GeorgetownUniversity's CreditResearchCenter, the actual APR of many tax refund loans is more than 100%. (What's APR? Read APR Vs. APY: How The Distinction Affects You.)
As a less-expensive alternative, you could adjust your W-4 form with your employer to reduce withholding from your paycheck; you'll have a smaller tax refund, but more money available to you in each paycheck. Furthermore, this option has no fees associated with it. (Still confused by your taxes? Check out our Income Tax Guide.)
The Preparer's Point Of View
RAL providers argue that the cost of the loan is justified by the riskiness of the loan, on the basis that there is a chance that the IRS will not issue a refund for a given tax return or will issue a reduced refund. For most RALs, there is no procedure for a tax preparer to request the return of a loan.
These loans are made possible by electronic filing: when a tax preparer submits your income tax return electronically, he or she receives confirmation within 24 hours that your tax return is error free. RALs are a good deal for tax preparers because there is a very good chance that the loan will be repaid in full. While tax preparers argue that the 24-hour waiting period represents a risk on their part, there is practically no chance of a tax preparer losing money if he or she has correctly prepared your tax return. In light of this, these loans aren't the best deal for taxpayers, especially those who can afford to wait the two weeks that is usually required to receive a federal tax refund from an electronically filed return. (To avoid needing a RAL, find out how to make your own emergency fund in Build Yourself An Emergency Fund and Are You Living Too Close To The Edge?)
The IRS has tried on a number of occasions to change the refund anticipation loan system in order to reduce misuse. Those efforts have been unsuccessful. The NCLC has also argued that many tax preparers do not educate their customers about RALs: many taxpayers have no idea of when they might expect to receive their refund and most do not understand the fees associated with their loans. Even well-known tax preparers have been accused of predatory lending practices: in 2002, H&R Block settled a suit brought by the New York City Department of Consumer Affairs for their RAL lending procedures and, in 2006, the company went to court with the State of California.
There are other continuing ethical concerns with RALs as well. Tax preparers can inflate expected tax returns to improve their profits: while this procedure is unethical, the gamble can sometimes be worthwhile. These tax preparers essentially bet that the IRS will not catch the changes made to their clients' tax returns and charge higher fees to make a profit.
The Future of Instant Refunds
The IRS hopes to unveil a new tax filing system by 2012 called the Customer Account Data Engine (CADE). This system will be able to process income tax returns and refunds within a 24-hour period, and taxpayers will receive their refunds within three days. The CADE system is expected to eliminate RALs entirely.
In the meantime, tax refund anticipation loans are widely available. Supporters of RALs describe them as a useful way of handling unexpected medical expenses, overdue credit bills and other expenses. However, the short-term nature of these loans makes them problematic at best.