When you shop for a mortgage, you likely hear the term PITI thrown around. What exactly does this term mean and how does it affect you?
The term stands for Principal, Interest, Taxes, and Insurance and it is what makes up your mortgage payment. When you talk to a lender about a potential mortgage, they will tell you the interest rate and the potential payment on the specific loan amount you need. However, you do not have all of the pertinent information until you add in the taxes and insurance, both homeowner’s and mortgage, that you must pay.
The Principal Part of the Mortgage
The principal of your mortgage is the actual money you borrowed. For example, if you need $200,000 to purchase a home, the $200,000 is your principal. The payment you make each month does not cover the principal alone – it includes the other factors talked about above. In fact, in the first few years of your mortgage payments, you pay very little principal and pay more towards the interest. Every little bit of principal you pay each month comes directly off of the full amount, as in the above example of $200,000.
The Interest Part of the Mortgage
The interest is the money the lender charges you in order to borrow the principal. You will hear the interest talked about in a percentage format. For example, a lender might quote you a 4% or 4.5% interest rate on your loan. In the beginning of your mortgage payments, interest will make up most of your mortgage payment. As you begin to pay the principal down, though, the interest starts getting smaller and you pay more towards the principal of the loan.
You can have one of two different types of interest – fixed or adjustable interest rates. Fixed interest rates remain the same throughout the life of the loan. For example, if you have a 4% interest rate for 30-years, the entire 30-years will consist of your 4% interest rate. If you have an adjustable rate loan, the rate will adjust according to the economic indices the mortgage is tied to. It will not adjust right away, though, it typically adjusts after the initial 3 or 5 years or the term specified in your loan documents. The introductory rate remains fixed for that time while the adjusted rate changes once per year.
The Tax Part of the Mortgage
Taxes – they are inevitable in almost everything we purchase, including your home. Depending on where you live, the real estate taxes you pay could be a significant part of your mortgage payment. When you shop for a home, always make sure to inquire about the property taxes in the area. The real estate agent or builder will likely give you a percentage; you use that number with the value of your home to figure out your real estate taxes. For example, if they tell you the rate is 1.5% and the purchase price of the home you want to buy is $150,000, your estimated real estate taxes would be $2,250 per year.
In order to figure out the tax portion of your mortgage payment, the lender divides the annual taxes by 12 months. However, they will often add a cushion to those taxes. Because the monthly tax portion of your PITI goes into an escrow account until the taxes are due and payable, the lender typically needs a cushion in the account. When you first set up your escrow, the lender will likely require you to pay an extra 2 months up front for the escrow. This takes care of any increases in your taxes down the road. After you own the home for a year, the lender will perform an escrow analysis to determine if they collected enough money for taxes each month. If your escrow account became negative, they will increase the tax portion of your payment. On the other hand, if your account has a surplus, they might decrease your payment. This analysis occurs on a yearly basis to determine your current tax situation.
The Insurance Part of the Mortgage
The last part of PITI is insurance. This can be twofold depending on the type of mortgage you have. The general definition of insurance is homeowner’s insurance as every lender requires it. This insurance is what protects not only you, but the lender as well. If something were to happen to your home, for example, a fire burned it down to the ground, you need insurance to help you build it again. Without proper insurance, you could walk away from the home and your loan, leaving the lender with a large loss.
Homeowner’s insurance works much the same as property taxes. Once you secure a policy with an insurance company, the total premium gets divided up into 12 equal payments. The lender pays the insurance bill for you and adjusts the insurance portion of your payment on an annual basis, if necessary. Typically, homeowner’s insurance premiums do adjust periodically, so the lender needs to adjust your payment accordingly.
Another component of the insurance part of the payment is mortgage insurance. Not every loan will have this insurance, though. If you have a conventional loan and you put down less than 20% you will pay it. You will also pay it if you have an FHA or USDA loan. The appropriate government agency that backs your loan bills the lender annually for your insurance, but just like property taxes and homeowner’s insurance, you pay the insurance on a monthly basis. The lender adjusts your payment accordingly as the required insurance payments decrease as your principal decreases.
PITI and What you can Afford
When you shop for a mortgage, it is important to figure the PITI payment, not just the principal and interest. You need to take a close look at your budget to see what you can afford. Even if the principal and interest seem affordable, if you purchase a home in an area where property taxes are high or the mortgage insurance puts your payment over the threshold of what you can afford, you might find it difficult to make your payments.
Calculate your PITI with every potential home purchase to know the full ramifications of what you are taking on. A mortgage is one of the largest investments you will make in your life, so understanding the full payment is very important. The lender will help you with this process as the full payment of principal, interest, taxes, and insurance is necessary to calculate your debt ratio to see if you qualify for the loan.