Have a low interest rate on your mortgage? Make sure you crunch the numbers before you pay down the principal.

The first rule of finance: pay off debts with higher interest rates first. With interest rates likely to rise in the near future as the Federal Reserve (the Fed) stops buying mortgage-backed bonds (MBBs) as it did to provide below-market rates during the financial crisis, a low mortgage interest rate may be the least costly of a homeowner’s consumer debt obligations. This is especially true when the added benefits of a tax deduction for mortgage interest payments in the early years of amortization are factored into the rate. [For a discussion of the mortgage interest tax deduction, see the March 2010 first tuesday article Getting rid of housing subsidies: the mortgage interest deduction]

Consider someone with a 5.00% interest rate on the mortgage encumbering his positive-equity home.  After factoring in the tax deduction and other tax benefits of ownership, his effective interest rate is around 3.25%.  The decision whether or not to pay down his mortgage is now based on a simple question:  would the money used to pay down the mortgage make more than 3.25% (the effective rate of interest) elsewhere?  [For a more complete calculation of the effective interest rate, see the full New York Times article referenced below.]

With interest rates going up as we turn from the financial crisis to fighting a recession-based recovery, it stands to reason that money would be better invested in higher-yield investments than in home equity. A further investment in a home by paying down a mortgage debt with a 3.25% effective interest rate is not an effective use of a wage-earner’s money.

In addition, paying down mortgage debt, while emotionally satisfying, puts a high balance of funds in an illiquid asset; that is, you can’t get to the money when you need it, as you can with a liquid savings account or bonds. Thus, savings and bonds provide more of a financial buffer than equity in a home does against financial shocks such as unemployment, illness or the death of a primary breadwinner. This is especially the case as home equity shifts in a dollar amount equal to the change in the value of a home—as millions of people were made painfully aware of during the Great Recession when the price of over-valued real estate took a dive.

first tuesday take: Emotionally, it is a meaningful and feel-good sensation to pay down a mortgage, but it’s always prudent to take a close look at the ramifications of any significant financial decision and compare them to available alternatives. If a homeowner has excess cash reserves beyond funds set aside for illness, education and other savings to provide certainty and to ensure he will realize his expectations for the future (read: as his insurance), he then has the money to pay down a mortgage and the luxury of erring on the side of emotions if he feels more secure by being debt-free. He has enough liquidity in his other assets to provide cash to absorb the shocks of loss, if and when they occur.

However, “feeling good” in being debt-free by paying down a mortgage does little to help someone who loses their job and has no reserves to pay bills. That person may lose their home anyway, if they are not able to quickly liquidate the equity in their property by selling. Owners of real estate must juggle a huge — almost unacceptable — risk of loss in their decision to pay down a mortgage (unless they are suffering from the enviable position of having too much excess money in reserve), as real estate, by nature, is a long-term endeavor. To offset that huge risk, and as long as the interest rate on his mortgage is not significantly higher than what he is able to earn elsewhere on investments, the homeowner must keep his reserves liquid and his 30-year, fixed rate mortgage intact.

Re:  “When Not to Pay Down A Mortgage” from the New York Times