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The Pros and Cons of Borrowing to Pay Tax Debt, from myFICO

Finding out that you owe taxes to the IRS can lead to a lot of…

  • June 2, 2021

Finding out that you owe taxes to the IRS can lead to a lot of stress, especially if you don’t have the cash on hand to pay in full by the due date.

The good news is that the tax deadline for 2021 was extended by a little over a month to May 17th.

That gives you a little more time to earn, save, and pay off as much of your taxes as you can before tax day.

But as that deadline fast approaches, you may be wondering if it would be a smart move to pay off the remainder of your tax bill using borrowed funds.

Using a loan to pay off your taxes could certainly help you pay on time. But would borrowing from a private lender cost you more or less than an IRS payment plan? And what other potential downsides need to be considered? Here’s what you need to know.

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Costs of Missing the Tax Deadline

There are a variety of penalties that you may be charged by the IRS if you don’t pay your taxes on time. You’ll also be charged interest on the unpaid amount.

The two most common penalties related to missing the tax deadline are failure-to-file and failure-to-pay. Below, we explain how these penalties are calculated as well as IRS interest charges.

Failure-to-File Penalty

This penalty is 5% of all taxes that are unpaid as of the tax filing due date. If you owe $3,000 in taxes, failing to file your return by tax day would result in a failure-to-file penalty of $150. The fee is charged monthly for up to five months or until a return is filed.

It should be noted that the failure-to-file fee applies for a full month even if you’re less than 30 days late on filing your return.

Also, once you’re more than 60 days late, you’ll be subject to a minimum late filing penalty. That penalty is the lesser of all the tax you owe or $435.

The late filing penalty is much heftier than the failure-to-pay penalty (which we’ll look at next). Additionally, every day that you wait to file your return increases your risk of becoming a victim of tax identity theft.

For these reasons, it’s critical that you make every effort to file your return by the deadline, even if you’re unable to pay your tax bill.

Failure-to-Pay Penalty

This penalty is generally 0.5% of all taxes that are unpaid as of the tax filing due date. The fee is charged monthly until the taxes are fully paid or until the charges reach 25% of the unpaid balance.

The monthly fee is increased to 1% once ten days have elapsed since the IRS has issued a final notice of intent to levy or seize property. Conversely, it’s reduced to 0.25% for taxpayers who are enrolled in a long-term payment plan.

This means that a $3,000 unpaid tax bill would result in a monthly failure-to-pay penalty of $15 if you weren’t on any IRS payment plan or were on a short-term payment plan. If you later joined a long-term payment plan, the fee would drop to $7.50 per month.

Interest Charges

The interest rate that the IRS charges individuals on underpayments is the short-term federal funds rate plus an additional 3%.

In March 2020, the Fed cut its target rates to 0% to 0.25% in response to the COVID-19 crisis. A year later, rates are still hovering near these all-time lows.

For this reason, the IRS interest rate is (as of writing) at a rock-bottom level of just 3% for individuals. Large corporations, meanwhile, are currently being charged an interest rate of 5%. Note that IRS interest rates are recalculated every quarter.

Advantages of Using a Loan to Pay Your Tax Bill

The first reason that someone would choose to pay their taxes with a loan would be to avoid all of the penalties and interest charges listed above. By using a loan to pay your taxes in full by May 17th, you won’t have to worry about accruing any of these extra costs.

Additionally, some people may feel more comfortable owing money to a private lender than to the IRS.

The IRS has the legal right to garnish wages and/or add liens to personal property after sending a few warning notices. Private lenders, however, are granted far less autonomy in their debt collection efforts.

In the case of a secured loan (such as a home equity loan), a lender does have the right to seize the property that was used as collateral if you don’t pay. But with unsecured debt, neither wages nor property can be garnished unless the lender brings the borrower to court and is able to win a judgment.

Downsides of Using a Loan to Pay Your Tax Bill

Borrowing to cover your taxes will help you steer clear of some IRS charges. But it’s important to understand that loans are by no means free. They come with their own set of upfront and ongoing costs to consider.

In many cases, what a private lender will charge you may be more than what you’d pay the IRS. For example, while the IRS charges a 3% interest rate, the average interest rate on a 24-month personal loan is currently 9.46%, and the average credit card interest rate is 14.75%.

There are also one-time fees to consider. Personal loans, for instance, often come with origination fees, and home equity loans typically charge closing costs. Sticking with home equity loans, it’s important to understand that they put your home at risk. Failing to keep up with your monthly payments could result in foreclosure.

Understanding Your IRS Payment Plan Options

The IRS offers both short-term and long-term payment plans for taxpayers who owe money. The short-term plan is for those who can pay in full within 180 days (temporarily extended from the standard 120 days due to COVID-19). There is no setup fee with this plan.

If you can’t pay your taxes in full within 180 days, you can apply for a long-term payment plan. These are installment agreements in which you make monthly payments. For these plans, the minimum setup fee is $31 (for those who apply online and set up automatic payments), but it can go as high as $225.

You’re eligible to apply online for a long-term payment plan if you owe less than $50,000 and have filed all necessary returns. Short-term plans can be applied for online if you owe less than $100,000 (in combined tax, penalties and interest). If you don’t meet those criteria, you’ll need to apply over the phone or by mail.

With either of these plans, you’ll still owe the failure-to-pay penalty until your tax debt is paid off or until the total amount paid in penalties reaches 25%. The fee is 0.5% for short-term plans and 0.25% for long-term plans.

Comparing Consumer Loans to IRS Payment Plans

There are three types of consumer debt products that are often talked about as options for paying a tax bill: home equity loans, personal loans, and credit cards. How does each compare to the IRS payment plans? Let’s take a look.

Installment Loans (Home Equity and Personal Loans)

The truth is that neither a home equity loan nor personal loan is likely to offer you a better rate than the IRS. The current IRS rate of 3% is simply going to be hard for any private lender to beat.

Also, unless you’re planning to take out a loan that’s at least 12 months or longer, your upfront costs will likely be higher than what you’d pay in monthly IRS penalties too. Personal loan origination fees typically range from 1% to 8%. And most home equity loans charge closing costs that often equal 2% of the 5% of the amount borrowed.

If it will take you several years to pay your taxes, an installment loan could make more sense since its fees are only charged once. IRS monthly penalties, meanwhile, can really add up over time. For example, if it took you 72 months (the maximum typically allowed) to complete your IRS installment plan, you’d end up paying 18% overall in failure-to-pay penalties (0.25% x 72 = 18%).

Of the two installment loan options, personal loans would probably be the best choice since they don’t usually require collateral. However, for extremely large tax bills, a home equity loan may be your only option for getting the loan amount that you need.

Credit Cards

But while installment loans may not be less expensive than an IRS payment plan, a 0% APR credit card most certainly would be. Taxpayers with strong FICO® Scores may be able to pay taxes with a credit card and receive an interest-free period of 12 months or longer.

Credit cards also don’t come with origination fees or closing costs. However, you should know that all three of the IRS payment processors do charge a credit card fee. As of writing, these fees are:

PayUSATax: 1.96%

Pay1040: 1.99%

ACI Payments, Inc.: 1.99%

It’s also important to remember that 0% APR cards revert to their regular interest rates once the promotional period ends. So you should only use this strategy if you’re certain you’ll be able to achieve a zero balance before that happens.

The Bottom Line

Over short time periods, IRS payment plans are likely to be the cheapest way to pay your taxes. However, applying for a loan could make more sense if you’ll be in repayment for several years, and your FICO Score would qualify you for an attractive interest rate.

If you’re eligible for one, paying your taxes with a 0% APR credit card could also be worth considering. But you’ll want to make every effort to pay off your balance during the introductory period. To gain a better idea of the financing options, you may qualify for, check your credit reports and scores at myFICO.

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What Can We Add to This? See Your Credit Union

Before doing anything, go see your credit union. Your CU can help you find the right options – like a low-interest personal loan for paying off debt. Your CU is not-for-profit and member owned, so you don’t have to worry that the advice your being given is more about a company’s profits and less about what’s in your best interests.