PITI

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What does PITI mean?

PITI (pronounced like the word pity) is a commonly used acronym in real estate transactions. It stands for principal, interest, taxes, and insurance. Together, these are the elements that make up a conventional loan’s mortgage payment.

Principal refers to the principal amount of the loan. Interest is the loan interest. Taxes refers to property tax. And insurance refers to homeowners insurance and any necessary premiums for private mortgage insurance (PMI).

Let’s break down each of those components in more detail.

Principal

This is the amount of the loan. So if a borrower takes out a mortgage for $250,000, principal describes exactly that sum: $250,000. Borrowers pay off a small portion of the principal at first through monthly mortgage payments, and over time the share of that monthly payment includes more of the principal.

Interest

Interest is the amount a borrower must pay for the privilege of borrowing money. After all, every loan comes with some risk to a lender in the event a borrower defaults. Early on in a mortgage loan, monthly payments may include a larger share applied toward interest than principal. Over time, the ratio shifts toward principal, which the buyer pays down.

Taxes

Local governments require that homeowners pay property taxes in order to fund public services in the area, such as schools, parks, and law enforcement departments. Taxes are calculated as an annual sum based on the appropriate property tax rate, and they can be included with each monthly mortgage payment if a lender holds the borrower’s funds in an escrow account, which is extremely common.

Insurance

This can include two kinds of coverage: homeowners coverage (to insure the home itself against disaster and theft), and PMI (required for people who put less than 20% down payment on a home). As with taxes, insurance premiums may be added to monthly mortgage payments; the lender holds the amount in escrow until payment is due, then pays the bills on behalf of the borrower.

Why is calculating and understanding PITI important?

PITI gives a fuller sense of all of the true cost of homeownership. In this way, it helps both lenders and borrowers avoid a situation in which a borrower can’t afford to make payments.

That is to say, would-be borrowers who only look at mortgage and interest payments might assume a particular home is within budget—without realizing just how much taxes and interest can add to those monthly payments, taking it out of range.

Mortgage lenders will only qualify you for the amount of money they think you can repay. By using this formula, you’re less likely to get into a house you can’t afford and end up in default. This way, both sides have a clearer picture of the size of loan that is feasible.

Usually, lenders quote PITI on a monthly basis. They compare it with a borrower’s monthly gross income and use it to calculate the borrower’s front-end and back-end ratios, which are used to determine approval for mortgage loans.

Front-end vs. back-end debt-to-income ratios

Typically, mortgage lenders want to see a borrower’s PITI is less than or equal to 28% of gross monthly income. That’s what’s known as a front-end ratio.

The back-end ratio compares monthly gross income against PITI as well as other monthly recurring debts, such as car payments. This figure is also known as the debt-to-income ratio (DTI ratio).

When purchasing a property with a homeowner’s association, such as a condo or gated community, the dues required by the homeowner’s association (HOA), must also be calculated into the PITI payment; these are a nonnegotiable part of the monthly financial obligation.

What is escrow?

Lenders pay the taxes and insurance into a borrower’s escrow account. From this, the lender distributes money—on the borrower’s behalf—when the bills come due for property taxes, homeowners insurance premiums, and any necessary mortgage insurance premiums.

This system can be a useful and convenient fool-proofing tool for borrowers: It simplifies the process, and spreads out the year’s bills over 12 evenly distributed payments. Plus, it prevents homeowners from accidentally overspending and failing to save enough to pay those bills when they come due.

An escrow account is required for many first-time homeowners. Borrowers will know if an escrow account is a requirement of the mortgage because it will be stated in the loan documents. 

If not contractually bound to an escrow account, some borrowers would prefer to take control of the tax and insurance bill payments on their own. For instance, some borrowers might prefer to manage their money in an interest-bearing account rather than having it tied up in the non-interest-bearing escrow. Some might want a lower monthly payment for other reasons. And for some borrowers—especially those who are both well-organized and disciplined—this approach is the right choice.

How much money does an escrow account need?

Many lenders require borrowers to keep a bit of extra money in their escrow accounts—and (as with other accounts needed to cover expenses) this can be a good idea anyway, so you know you have your expenses covered.

But there are state- and federally regulated limits on how much extra you can be required to hold in this account. The lender can hold in escrow enough of the borrower’s money to pay the annual property taxes and insurance premiums as well as an extra buffer; this cushion cannot be more than two times the monthly escrow funds plus $50, per the Real Estate Settlement Procedures Act.

Property taxes and insurance premiums can fluctuate from one year to the next. The lender will provide an annual escrow analysis to confirm the borrower is funding it properly.

If a borrower’s insurance premiums or taxes go up, the lender might increased the required escrow payments so there’s always enough in the account to pay the bills.

What happens if taxes and insurance change?

Still, the borrower’s bills might exceed the amount of money in the escrow account. If this happens, the lender will step in and cover the difference, paying in full the amount the borrower owes. In the event this happens, the borrower will see this shortfall identified on their escrow analysis statement as a negative balance. And the lender will give options to repay this amount—typically either via a lump sum or payments distributed monthly.

If insurance premiums or property taxes shrink, the lender might reduce the borrower’s monthly amount in escrow. If, through the escrow analysis, the lender finds that the borrower has too much in an escrow account, the lender might issue a refund check for the overage.

How is PITI calculated?

Calculating PITI is needed to figure out how much home you can afford. And it helps determine the type of loan and down payment a buyer will need to close the deal.

Online mortgage calculators such as BiggerPockets’ simple PITI calculator can help you easily calculate the expenses. You will need to enter several numeric figures in order to get your result, estimating any unknowns.

First, type in the mortgage amount you’ll need (the price of the home, subtracting the down payment). For instance, if you plan to put 20% down on a $500,000 home, the mortgage amount would be $400,000. If you’re not looking at a specific home yet, you can enter an estimated mortgage amount based on typical home prices in your target area. 

You’ll also need to put in your loan terms, usually 15 or 30 years. A simple rule of thumb: A longer mortgage usually results in lower monthly payments but higher interest payments versus a shorter one. Amortization refers to the scale that determines how much of the monthly mortgage premium is going toward the principal on the loan, versus how much is being applied to the interest.

Also include the interest rate in the mortgage calculator. These change frequently, but BiggerPockets and other resources post current mortgage rates online for guidance. Your own rate is determined by various factors including your down payment and credit score.

You’ll also need to estimate a figure for your annual property tax. The property’s listing might include this data. Information on tax rates is also available on the local property tax assessor’s website.

Last, you’ll need to estimate your annual bill for homeowners insurance, which also varies according to the specifics of each home and its location.

With all of this data, buyers can calculate (or estimate) PITI, playing around with potential home prices and down payment amounts to see what’s really affordable.

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