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Mortgage Basics

What Is Principal, Interest, Taxes, and Insurance (PITI)?

PITI is an acronym that stands for "principal, interest, taxes, and insurance." Combined, these components make up your monthly mortgage payment.

As you're shopping for a home and trying to figure out your budget, it's important to consider all four factors of PITI. Here's a closer look at each one, and what you need to know as you prepare to buy your next home.

Principal

The principal amount of your loan is what you borrow from the mortgage lender to buy a home. On a monthly basis, the principal is the amount of your payment that goes toward paying down the loan.

The longer you make payments on your loan, more of your payment will go toward paying down your total principal.

For example, let's say you purchase a home for $250,000 and put down 20% or $50,000; your total principal amount is $200,000.

Now, let's say you get approved for a 30-year loan with a 4.25% fixed interest rate. Using a mortgage calculator, your monthly payment (excluding taxes and insurance for now) would be $984, which includes both principal and interest.

For your first month, just $276 of your payment goes toward paying down the loan, and the rest goes toward the interest. At the five-year mark, that principal amount goes up to $339, and after almost 14 years, you'll start paying more toward principal than interest.

If you want to pay down your mortgage faster, most mortgage lenders allow you to make extra payments each month, with most or all of the amount going toward principal.

Interest

Interest is the amount a lender charges for the opportunity to borrow money. At a basic level, there are two interest terms to understand: interest rate and annual percentage rate (APR).

Interest Rate vs. APR

An interest rate is a number the lender uses to determine how much interest you owe on the loan for each monthly payment. The interest rates lenders advertise, such as 4.25%, is the annual interest rate.

An APR, on the other hand, is comprised of the interest rate, fees, and other costs of financing. Mortgage companies are required by law to disclose the loan's APR in addition to the interest rate.

Fixed Rate vs. Adjustable Rate

The two most common types of mortgage loans are fixed-rate and adjustable-rate mortgages. A fixed-rate mortgage keeps the same interest rate for the life of the loan. An adjustable-rate mortgage (ARM) allows for your rate to go up and down as market rates fluctuate.

Adjustable-rate mortgages typically charge lower interest rates to start because the lender is shifting the risk of market rates going up to the borrower. While that may be tempting, the rate can eventually exceed what you would have paid with a fixed-rate mortgage.

To make ARMs more appealing, many mortgage lenders offer a hybrid loan, such as a 5/1 ARM. This means that your interest rate stays fixed for the first five years, then it adjusts to market rates on an annual basis after that.

Depending on the lender, there may be limits on how high the rate can go each year. For example, if market rates increase by 2% and your annual cap is 1%, you'll only see a 1% increase. There may also be a lifetime cap, such as 5%, in case of interest rates skyrocket.

Calculating Interest Costs

Now, let's go back to our example above of a $200,000 loan with a 30-year repayment and a 4.25% fixed interest rate. To calculate how much interest you owe each month, you divide the annual interest rate by 12, then multiply that amount by the current principal amount.

For example, 4.25% divided by 12 is roughly 0.354%. Multiply that by $200,000, and your first monthly payment of $984 includes $708 in interest and $276 in principal. For the second month, your total principal amount is now $199,724, so the interest portion of your monthly payment will be $707, and so on.

Over time, the interest portion of your monthly payment will decrease as you pay down the loan.

The Tax Benefits of Mortgage Interest

As of 2018, mortgage interest is tax-deductible on qualified mortgage loans of up to $750,000. The mortgage interest deduction is an itemized deduction that can reduce your taxable income.

To take advantage of it, though, your total itemized deductions, which also includes things like charitable donations and unreimbursed medical and dental expenses, must be higher than the standard deduction amount. For 2018, that's $12,000 for single filers and $24,000 for married couples filing jointly.

Taxes

Property owners are required to pay property taxes to their local governing body, typically the county in which they live. Property taxes are usually due on an annual basis, but many mortgage lenders break the payment down monthly and include it in your regular payment.

Rather than go toward your mortgage, however, your monthly tax payment is typically set aside in an escrow account. Then when the tax bill is due, the mortgage company pays it on your behalf.

They don't do this out of the goodness of their hearts, though. Rather, they do it because if you miss property tax payments on your own, the government could foreclose on your home and the leave the lender out in the cold.

That said, some lenders allow you to pay property taxes on your own without an escrow account. Local property taxes are tax-deductible on your federal income tax return.

How Much Are Property Taxes?

Property taxes vary by state and county and can change each year. You can get an idea, however, based on the state you live in.

For example, according to the National Association of Home Builders, New Jersey has the highest property taxes in the country with a 2.14% average across all its counties. In contrast, Hawaii has the lowest property taxes in the U.S. with a 0.29% average.

To get an idea of what your exact property tax rate is, contact your county's tax assessor.

Insurance

Depending on your loan type and down payment amount, you could pay two different types of insurance with your monthly bill: homeowners insurance and mortgage insurance.

Homeowners Insurance

You can legally own a home without homeowners insurance, but if you have a mortgage on your home, your mortgage lenders will require it to protect their investment.

Homeowners insurance is designed to cover your home's structure and your personal belongings if they're damaged or destroyed by an eligible loss. It can also protect you against liability issues, such as someone getting injured on your property.

Covered losses typically include:

  • Fire and smoke
  • Windstorms
  • Hail
  • Lightning
  • Theft
  • Vandalism
  • Water damage
  • Snow and ice

Damage from an earthquake or flooding typically requires a separate insurance policy.

The cost of homeowners insurance can vary depending on where you live and the makeup of your home. But in general, expect to pay $35 per month for every $100,000 of home value on average. So, on a $200,000 loan, you might pay $70 per month.

Homeowners insurance is typically paid once a year, but many mortgage lenders include it in your monthly payment and set it aside in your escrow account along with your property tax payment.

Mortgage Insurance

If you have a conventional mortgage loan and don't put down at least 20% when you buy your house, the lender will typically require that you pay private mortgage insurance (PMI). This insurance policy protects the lender if you default on the loan.

Typically, PMI costs between $30 and $70 for every $100,000 you borrow. So, if your loan is for $200,000, your monthly premium could be anywhere between $60 and $140.

PMI is not permanent, though. Once the loan balance reaches 78% of the original value of your home, mortgage lenders are required by law to drop the policy.

Alternatively, if your loan balance reaches 80% of the original value of your home, you can request that the lender remove PMI. In this case, however, the lender can require an appraisal to prove that the value of the home hasn't dropped since you first bought it.

If you have an FHA loan, you'll pay a different type of mortgage insurance called a mortgage insurance premium (MIP). This includes an upfront MIP of 1.75% of the base loan amount and an ongoing MIP rate of 0.45% to 1.05%, depending on your loan amount and down payment.

If you put down at least 10% on your FHA loan, MIP will fall off after 11 years. If your down payment is less than 10%, however, it remains on the loan for the entire term.

Do Your Homework Before Buying

As you determine your budget for a home, it's important to consider all the factors that go into your monthly payment. Take the time to estimate each based on the average price of the homes you're considering, and make sure you can afford it.

To give you an idea of whether a monthly payment is affordable or not, mortgage lenders often look at your debt-to-income ratio and use the 28% rule. This means that your overall monthly housing costs should not exceed 28% of your gross monthly income.

So, if you earn $60,000 per year, your gross monthly income is $5,000, and your total monthly payment should be no more than $1,400.

If, however, you have other debt obligations, you may need to go even lower than that with your mortgage payment. Speak with a loan officer or mortgage broker to better understand what fits in your budget.


Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.

This article was originally published on November 13, 2018, and has been updated.

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