Homeownership is an expensive undertaking, no matter how you look at it. To own a home is to take a large step financially. And we’re not just talking about first time home buyers either. Getting your first mortgage is a huge deal, but that’s not to say it isn’t just as complicated or lacks any financial importance for any recurring home purchase.
There are quite a few websites, most of which belong to lenders or mortgage brokers, that have articles that stress the importance of knowing just what you’re getting into financially when looking to purchase a home. And there is a reason behind it. As it turns out, there are a number of home buyers who are unaware of the actual costs associated with owning a home -- rather than just the upfront purchase process.
Of course, it isn’t their fault they’re unaware! When searching for the perfect mortgage, the perfect loan package, and the perfect lender, borrowers typically only pay attention to three aspects of home ownership costs: closing costs, the principal loan balance, and interest.
And while these are definitely things that homeowners must absolutely focus on when taking out a home loan, they are actually a part of a bigger picture. In reality, your monthly mortgage payments will most likely have to account for more than just the principal and interest. When trying to calculate the cost of homeownership, consider your “PITI”, since it is closer to what you should actually plan ahead for cost-wise.
What Is PITI?
PITI, for those who haven’t heard the term before, is an industry acronym that stands for principal, interest, taxes, and insurance. It is important to understand that paying for a home goes beyond the obvious expectations of principal and interest payments.
Like nearly everything else in this country, homeowners are also responsible for taxes associated with homeownership and as if that weren’t enough, it is almost always a requirement to carry some form of home insurance.
When all of these costs are properly calculated, the end result is PITI. PITI is a much better representation of what a home buyer’s monthly expenses will look like after purchasing a home. The components of taxes and insurance are too easily left out of the equation when shopping around for home financing when truthfully, a mortgage payment is meant to be the complete combination of all four payment components.
It’s almost predatory lending when banks and lenders promise low monthly mortgage payments “in the hundreds”. While most of the time they aren’t lying, they are typically only referring to principal and interest portions of the monthly payment. They choose to omit the necessary components of taxes and insurance, which can easily double the monthly cost.
Often, home buyers wrongfully assume the affordability of a home purchase because of these misleading figures, and end up in a sticky situation down the line when they discover the actual payment amount. PITI is meant to represent a complete mortgage payment. As such, it is up to the borrower to figure out the true amount they will need to pay each month by calculating PITI instead of only taking principal and interest into account.
Every component of PITI represents a unique portion of a homeowner’s monthly cost. While principal and interest are the most focused on of the four components, it behooves anyone purchasing a home to know what each component is, and how it factors into monthly mortgage payments.
Next, we’ll break down each component of PITI.
Of the two most discussed portions of a mortgage payment, the most important value is the principal. The principal amount of a mortgage is the amount that you’re borrowing. The portion of a mortgage payment referred to as “principal” simply means the portion of the total monthly payment that goes towards repayment of the principal loan amount.
Your principal payment component and principal, in general, is determined by how much you are actually borrowing for your mortgage. You see, just because a home costs a certain amount doesn't necessarily mean that value becomes the principal amount. In fact, down payments are typically meant to chip away a portion of principal upfront, in order to show that a borrower is serious, and has the means of repaying the entire principal amount.
For example, imagine you want to purchase a home that costs $200,000. Depending on the loan program you qualify for and eventually choose, you may be required to make a down payment. Typically, most lenders expect a down payment of at least 20%, which would mean a cool $40,000 in this scenario. That means that you would only need to borrow a home loan of $160,000, which becomes the principal loan amount.
The repayment of this principal amount is handled as a portion of every monthly mortgage payment that is made. This is where amortization comes in. Amortization is a repayment schedule that splits monthly payments of principal and interest accordingly so that by the repayment date, a borrower has paid the principal in full, as well as the interest.
This is done over the course of the selected loan term, typically 15 or 30 years, depending on the loan program. That isn’t to say that the principal can’t be paid sooner, as there are plenty of loan options that don’t penalize paying more than what is required each month in order to chip away the principal balance faster than the set loan term.
Then again, there are some loan packages that don’t allow early repayment and many more that charge prepayment penalty fees in order to discourage the early repayment of the principal balance.
How a lender treats the repayment of principal is important and is mostly due to the next component in a standard monthly mortgage payment, the interest.
The second component of a full PITI payment is the one that gets the most attention: the interest. The Interest of a loan is the most negotiated and discussed payment component during the home buying process, and for good reason.
The interest on a home loan is the cost of borrowing the principal amount. That is to say, when you borrow money, you must not only repay what you borrow, but a fee based on a percentage of that principal amount. This is what's known as interest.
Everyone who has even remotely dealt with a home purchase can tell you that the interest rate on potential mortgage products get all of the attention in the early stages of the home buying process. Borrowers typically do anything they can to get the lowest possible interest rate for their home loan. The interest rate, expressed as a percentage, defines how much they will pay each month and over the course of the loan term for borrowing the principal sum.
When shopping for a home loan, it is important to pay close attention to the annual percentage rate, or APR. While you may see a quoted “interest rate” for any given loan type, the APR represents the total cost of the loan (in terms of interest) after all additional fees are taken into consideration.
The APR is then evenly distributed throughout the monthly payments thanks to amortization, with most of it being paid in the earlier portion of the loan term, before gradually giving way to higher portions of principal being paid in the latter half of the loan term.
Amortization makes it so that your monthly payment amount doesn’t change, but the proportions of principal and interest that each payment contains do. Still, the APR is a predetermined interest amount based on a percentage of the principal amount borrowed, so no matter how much interest is paid in any given month, it is all going towards that agreed upon amount.
Using the same example from before, let's say that you borrow $160,000 at 4.8% APR. That amounts to the sum of $7,680 in interest to be split among the monthly mortgage payments throughout the loan term. To put it another way, think of it like owing $167,680 in total.
Of course, this level of predictability is only true when the interest rate is fixed. An adjustable rate mortgage carries an interest rate that fluctuates based on the rise or fall of a benchmark rate. This means that there is no solid value that can be assigned to the interest cost, since the rate is subject to change, typically on a yearly basis.
Regardless, each and every monthly mortgage payment contains an interest component. And while it is beneficial to know the combined value of principal and interest in a single payment, that still doesn’t quite make up a complete payment amount. There are still two lesser-known payment components that must be considered: the first of which is taxes.
Finally venturing past the two most popular portions of a full PITI payment, we arrive at taxes. Anyone living in this country will have heard, by now, that there are only two things in life that are guaranteed: death and taxes. Let’s be honest, while science may very well put an end to that first thing someday, we’ll probably never be without taxes.
Homeownership is no exception to this rule, yet many home buyers do not take taxes into account when shopping for a new home. The sad truth is that every house or property is subject to what is known as property taxes. Property taxes, sometimes known as real estate taxes, are paid towards the local government of authority over the location of the purchased home.
Property tax is assessed by the local government as a means of funding necessary public services such as law enforcement, fire departments, sewage and water treatment, road and highway construction, education, public servants, and anything else that serves the community as a whole.
It is important to remember that property tax rates and the types of properties taxed vary based on government jurisdiction, so it is always wise to inquire about the property tax for any new property purchase.
Property tax is determined by the local government of jurisdiction by taking into account the tax rate for the city as well as the current assessed market value of each property, including the land that it is on.
The tax rate is typically recalculated annually in most cases, and market value is also a fluctuating amount that draws on a plethora of different factors.
Assessed Value of Your Home
The assessed value of the home, which can be more or less than what the property was appraised for at the time of purchase, can change throughout the life of the loan whenever the local government assesses home values. Improvements or significant changes made to a home or property can affect the assessed value, and by extension, the amount you pay in taxes.
To better understand, using our same home purchase example, let’s say that the home is assessed at $200,000 in value. The municipal tax assessor assigns a property tax rate of 3%, which brings your property tax amount to $6,000 for the year. When divided evenly among the monthly payments, it ends up being an added $500!
While that example may seem a bit much, that is the reality of property taxes. What's worse, is that the value you have to pay can change over time, so an increase isn’t a far fetched scenario. Luckily, virtually all local governments allow property tax rates to be contested by the property owner, so you may have a shot at reducing what you have to pay Uncle Sam.
Be wary though, unpaid property taxes can lead to a lien on the property, and eventually, if left unpaid, complete seizure. It is a prudent move to always look into any liens that may be on a property that you are looking to buy.
Property taxes are typically paid via an escrow account managed by your lender. Every monthly mortgage payment contains a portion that the lender allocates into this escrow account. When taxes are due, the lender arranges the payment through the escrow account.
Hopefully, now you can comprehend how even the simple addition of a property tax can raise a monthly mortgage payment by hundreds of dollars. Still, taxes aren’t the last of your concerns. There is still one more key component to PITI to take into consideration.
The last component of PITI comprises the different types of insurance that homeowners are expected to pay. More commonly, this portion is associated with homeowner’s insurance which is almost always a requirement that lenders have as part of any mortgage deal. Even so, mortgage insurance, which can be required of some borrowers also fits into this component.
Homeowner’s insurance is a huge deal, seeing as how its purpose is to provide coverage in the event of theft or damage to the property. It is extra cost, but well worth every cent. Some areas require more than the average home insurance policy and may require homeowners to purchase additional coverage such as earthquake or flood insurance which are typically separate policies.
Since lenders are using the property as collateral against the principal loan amount, you can be sure that the vast majority of them choose to make the purchase of homeowners insurance mandatory and part of the mortgage deal. After all, it is only natural to want to protect an investment. Mortgage transactions are nearly all hinged on the ability of the home buyer to show proof of insurance to the lender for this reason.
When purchasing a home, finding out if there are any special insurance policies required is crucial. There have been cases where mortgage transactions get nullified because of a lack of something as simple as flood insurance, even when a general home insurance policy has been purchased. For this reason, mortgage lenders often offer mortgage insurance in-house at an extra cost as part of the transaction, though home buyers always have the option to buy privately through a third party insurance company.
Much as in the case of property tax, homeowners insurance is usually paid via an escrow account managed by the lender. In most cases, it is the same account, as a matter of fact. Payments towards the home insurance come directly from the escrow account on the property owner’s behalf.
Private Mortgage Insurance or Mortgage Insurance Premium
The second type of insurance, mortgage insurance, isn’t always a requirement, but home buyers who fail to meet the industry standard down payment requirement of 20% and home buyers with FHA loans typically have some form of mortgage insurance that must be paid. Home buyers who fall short of a 20% down payment are usually required to pay private mortgage insurance or PMI. The Federal Housing Administration, as part of its requirements for accepting borrowers who meet tremendously flexible eligibility criteria, is well known for the requirement of mortgage insurance premiums or MIP.
In both cases, the “insurance” is not actual coverage for the buyer. Instead, mortgage insurance is coverage for the lender, should the borrower default on a monthly payment. Borrowers that get hit with mortgage insurance have additional money to pay out each month, and with MIP, there is even an upfront cost due at closing.
Private mortgage insurance, like homeowners insurance can be shopped around for, so there is no set standard of how much you might have to pay each month. In the case of mortgage insurance, it is typically a percentage of the loan amount that is charged on a yearly basis, divide up evenly between the monthly payments. Luckily, in most cases, mortgage insurance can be canceled once a homeowner builds up at least 20% equity by paying their monthly mortgage payments as scheduled.
Whatever your insurance situation may be, it is important to factor theses costs into your projected monthly mortgage payments.
Why PITI Is Important
Now that you have a good idea of what PITI comprises, you can see a clearer picture of just how important it is to focus on more than just the principal and interest portions of your monthly mortgage payment. With the addition of taxes and insurance, a payment thought to be well within the hundreds can jump easily into the thousands. Getting a better, more detailed idea of what is expected of a homeowner financially is crucial to the survival of any homeowner.
Take for example the same fictional home purchase we have been discussing in previous examples. A $200,000 home purchased with an interest rate of 4.8% with a full down payment of $40,000 leaves a principal and interest payment of only $839.46. That's not so bad for a 30-year mortgage, right?
Well lets go ahead and factor in that aforementioned tax rate of 3%, with the assessed home value of $200,000. That means a full $6000 due in taxes for the year. Divided into equal installments over twelve months, and that adds $500 to your monthly mortgage payment, meaning a total of $1,339.46 -- and that’s not even counting the insurance component!
Luckily, we’ve made a full down payment in this scenario, so let's forget about mortgage insurance. Still, homeowner’s insurance is a requirement, and even with a home buyer’s ability to shop around for the most affordable policy (barring the need for a separate flood or earthquake policy), the average annual home insurance premium for a $200,000 home with a $1,000 deductible and up to $100,000 worth of coverage is roughly $1,288. When divided up between your monthly payments, that adds another $108 to the equation, bringing the grand total up to a whopping $1,447.46!
To reiterate, that's a difference of $608 dollars from the simple principal and interest calculation. For home buyers looking to budget ahead, getting surprised by these figures in the long run can lead to serious financial hardship or even foreclosure. This is especially important for first time home buyers, who can be easily swayed by the affordability of the simple principal and interest calculations.
Planning ahead, and knowing the full affordability of homeownership is not just a suggestion, it is something that should be done every time you buy a home. We urge home buyers to look into property taxes and required insurance policies as soon as they are serious about any particular property. Even if the insurance will be handled by a third party, or the taxes are to be paid directly by the buyer, they are still monthly expenses that should be factored in along with your mortgage payment to get a better understanding of what you can afford when purchasing a home.
The good news is that many lenders, believe it or not, do care about PITI and how a potential borrower may or may not be able to afford it. It only makes sense, since the last thing a lender wants is for a borrower to default on a mortgage agreement. As such, most lenders tend to base eligibility on whether or not a home buyer can afford to pay full projected PITI costs.
As part of the mortgage application process, it is not uncommon for lenders to confirm whether or not the projected PITI cost exceeds a specific percentage of your monthly income. This calculation is sometimes known as your front-end debt-to-income ratio (DTI). The calculation is simple, it is just the estimated PITI amount divided by your gross monthly income. The result, expressed as a percentage, is your front-end DTI. The acceptable percentage varies by lender, so it helps to discuss this in full when meeting with potential lenders.
Of course, PITI must also be included in a borrower’s full or “back-end” debt-to-income ratio calculation as well. This calculation includes not only PITI, but all other monthly expenses a borrower may have. The back-end DTI is what matters most, since it measures a borrower's ability to afford the cost of a mortgage in addition to all of their other expenses. For a lender, that helps to determine the risk of loaning money to the home buyer, and for the home buyer, it is invaluable information as far as budgeting is concerned.
Other Expenses to Consider
While understanding PITI costs should put you leaps and bounds ahead of the game in terms of determining what your monthly costs should look like when purchasing a home, it still isn’t an exact picture. Homeownership comes with so many added expenses that often get overlooked until the bills are due. That is why buying a home is ultimately the largest investment the average person will make in their lifetime.
When trying to figure out monthly expenses, there are a few extra costs directly related to owning a home outside of PITI that need to be accounted for. Such expenses include utility bills such as electricity and water, maintenance costs, and for some, even homeowners association (HOA) dues.
Utility payments vary depending on the location of the property as well as how much a homeowner uses a utility, so they can be sort of hard to pin down. Same goes for any given maintenance expenses. The best way to get an idea of how much these costs will amount to is to ask the previous occupants of the home how much they spent on these expenses each month.
As for homeowners association fees, entering any community with a homeowners association in place means being notified of the monthly HOA dues beforehand. Many real estate websites tend to include the figure in the property listing anyway, so HOA fees are hardly ever a surprise.
PITI: In Review
It’s easy to get lost in a sea of figures when trying to calculate the cost of owning a home. It’s no wonder why many people choose to rent, and put off homeownership as long as they can. Entering into a mortgage transaction isn’t just a long term commitment, it's also a huge financial undertaking.
When buying a home, always make sure to look beyond principal and interest to determine what your monthly mortgage payments may look like. It is all too common for home buyers to overlook the huge impact that property taxes and homeowners insurance play on a monthly mortgage payment. An oversight of that magnitude could lead to serious financial repercussions, not to mention the possibility of foreclosure.
At home.loans we want every home buyer and homeowner to educate themselves before making any decision in regards to their home finances. If you would like to learn more, or would like a risk-free consultation with a mortgage specialist, all you have to do is contact the experts at home.loans, and our team will help you find the mortgage solution you’re looking for.