Paying down debt can be an astute financial move. As you reduce your debt load, you’ll owe less interest and have more money to spend or invest. Paying down a loan where the interest rate is, say, 6% is like earning 6%, risk-free.
Where can you find cash to pay down debt? One tactic is to use funds currently held in a bank account or a money market fund. Earning 6% by paying down a 6% loan is much better than earning 1% or less from cash equivalents these days.
However, there’s a downside to tapping your cash reserves to pay down debt. You won’t have as much money on hand in case of an emergency. Many advisors suggest keeping six months’ worth of expenses in cash.
Say you generally spend $4,000 a month. You might decide to keep $24,000 in cash: six times $4,000. Larger amounts could be moved from your bank accounts or money market fund to pay down debt and effectively earn a higher return. Using excess cash reserves to pay down debt is especially attractive if you have credit card balances charging you annual interest of 10% or more.
