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Personal Financial Planning — Part 2: Managing Basic Assets · 10 of 12
Personal Financial Planning — Part 2: Managing Basic Assets
finance CRITICAL

Mortgage Affordability & Amortization

Personal Financial Planning — Part 2: Managing Basic Assets Gitman, Joehnk, and Billingsley
mortgage affordability amortization PITI down-payment points housing

Key Principle

Mortgage affordability is governed by two independent constraints — an income ratio cap and a down-payment cap — and the binding limit is whichever produces the lower maximum home price. Most buyers assume income is the bottleneck; in practice, savings often bind first because closing costs consume roughly one-third of available funds before any dollar touches the down payment.

Why This Matters

A buyer who qualifies on income alone may still be locked out by insufficient savings. Conversely, someone with ample savings but high existing debt may hit the income ceiling first. Analyzing only one constraint produces a fictional affordability number. The dual-constraint framework prevents overcommitment and reveals where to direct effort (pay down debt vs. accumulate savings).

Good Examples

Schmidt Family dual-constraint analysis (pp. 165-167):

  • Income: $75,200/yr ($6,267/mo). Savings: $30,000. Rate: 6%, 30yr. Min down: 10%.
  • Down-payment funds after closing cost reserve: $30,000 x 2/3 = $20,100.
  • Income-based max home price: $250,100 (max loan $230,000 + $20,100 down).
  • Down-payment-based max home price: $201,000 ($20,100 / 0.10).
  • Binding constraint: $201,000 — a $49,100 gap below income capacity.

Amortization cost revelation (p. 163):

  • $100,000 at 5%, 30 years: total interest ~$93,255, nearly equal to the principal itself.
  • Year 1: only $1,475.34 goes to principal vs. ~$4,966.50 to interest.
  • Principal does not exceed interest per payment until around years 18-19.

Debt crowding out mortgage capacity (p. 164):

  • On $4,500/mo gross at 25% PITI cap, max PITI = $1,125.
  • With $500/mo in existing installment debt and a 33% total-debt cap, effective max mortgage payment drops to $985 — a 12.4% reduction from the headline number.

Counterpoints

  • The textbook ratios (25-30% PITI, 33-38% total debt) are conventional lender guidelines, not universal laws. Aggressive borrowers or alternative lenders may stretch these, but doing so increases default risk.
  • Shorter maturities (15-year) dramatically cut total interest but raise monthly payments, potentially violating the income ratio even when long-term cost is lower.
  • The 1/3 closing-cost assumption is a planning heuristic. Actual closing costs run 5-7% of home price, so the reserve fraction varies with purchase price and negotiated terms (p. 162).

Key Quotes

  • "Determining the largest mortgage for which you qualify is just the first step. You also need to consider your lifestyle needs." (p. 164)
  • "Closing costs are like down payments: they represent money you must come up with at the time you buy the house." (p. 162)
  • "It's preferable to pay insurance and taxes yourself, if you have the financial discipline. This strategy provides greater cash flexibility and an opportunity to earn a higher rate of return on funds than the escrow account pays." (p. 165)
  • "It's important not to base the rent-or-buy decision solely on the numbers. Your personal needs and the general condition of the housing market are also important considerations." (p. 159)

Rules of Thumb

  1. Dual-constraint test: Always compute both the income-based and down-payment-based maximum. The lower number is the real ceiling.
  2. One-third closing reserve: Assume only two-thirds of savings are available as down payment; the rest goes to closing costs.
  3. PITI cap: Monthly PITI should not exceed 25-30% of gross monthly income; total installment debt (PITI + all other) should not exceed 33-38%.
  4. Amortization front-loading: In the first 15-20 years of a 30-year mortgage, 85-90% of each payment is interest and taxes. Tax deduction value is highest early and declines.
  5. Points breakeven: Points increase effective APR dramatically on short holds — 0.70% per point if held 3 years vs. 0.11% if held 30 years (p. 161). Do not pay points if you expect to move or refinance within 5-7 years.
  6. PMI termination: PMI must be cancelled by law at 78% LTV on post-1999 loans (p. 161). Track equity actively to avoid overpaying.
  7. Non-mortgage debt reduces mortgage capacity dollar-for-dollar within the total-debt ratio. Pay down installment debt before house-hunting to expand borrowing room.
  8. Mortgage cost reference: At 6%/30yr, each $10,000 borrowed costs $59.96/month; at 5%/30yr, $53.68/month (p. 164).

Related References

  • rent-or-buy-analysis (rent-vs-buy cost comparison, opportunity cost on both sides)
  • closing-costs (detailed breakdown of cash-at-closing requirements)
  • tax-planning (deductibility of mortgage interest and property taxes)