Last week we started on a series discussing mortgages. When all the posts in the series are complete, you should have an understanding of mortgage types, structure, rates, points, fees, mortgage insurance, and refinancing. This week let’s discuss mortgage structure, and what is PITI.
- 1 – Common Types of Mortgages
- 2 – Mortgage Structure, What is PITI?
- 3 – Interest Rate vs APR
- 4 – Origination Fees and Closing Costs
- 5 – Discount Points
- 6 – Private Mortgage Insurance (PMI)
- 7 – Refinancing
What is PITI?
PITI is an acronym you may have seen thrown around before. It stands for Principal, Interest, Taxes, and Insurance. These 4 elements all go into how a mortgage is structured, and in many instances, deciding if you qualify. Let’s take a look at each element:
This is the actual amount of your loan. As you make mortgage payments, you will chip off a bit of your principle. As you do, you build equity in your home. Equity is literally how much of your money is invested in the home. When you first buy the home, your only equity will be however much you put down on the loan. Building equity with a mortgage is a slow process if you follow the payment plan laid out by the lender.
This is how much a lender charges to loan you money. It is calculated as a percentage of how much principal you have left to pay. That percentage will stay the same even though the percentage of your principal paid in a given payment will change as the loan moves forward. Interest payments are typically front loaded in the beginning of the loan, and as the loan is paid off the amount to principal goes up. Don’t confuse interest rate with APR, we’ll get to that in a future post.
Property taxes are generally levied by local governments and are used to maintain operation of that government. It’s a hot topic and politically charged. Especially when taxes are mismanaged in a given county or municipality. But for the most part, taxes are supposed to be used for:
- Government offices such as the courts or county clerk, commission, or animal control
- Local road maintenance, traffic lights, signs, etc
- First response units such as police, fire, or EMS
- Public schools and interscholastic facilities
- Utility infrastructure (water, sewer, trash, etc)
- Municipal facilities such as parks, greenways, or pools
Insurance and taxes are collected as you go through the year and put into an escrow account. Usually, you can check this account balance and see what the mortgage company is paying out to both your government and insurance company. For the most part, insurance covers you against fire and other incidentals. But it’s possible to add high value items such as artwork, wedding rings, or other tangible items to your policy. If you put less than 20% down on the home, you’ll also be required to buy private mortgage insurance (PMI) which will be covered in a later post.
Additional Factor Lenders Use (DTI)
Debt-to-income ratio (DTI) is probably one of the biggest factors when deciding if you’re too risky to lend money too. There are two DTIs you’ll hear about known as front-end and back-end ratios. When you see it written, it looks like Front-End/Back-End.
- Front-End Ratio is the percentage of your income that is required for housing costs, this includes PITI and HOA fees/dues.
- Back-end Ratio is the percentage of your income that goes to paying ALL recurring debt payments including your Front-End Ratio. This includes car loans, credit cards, student loans, child support, etc.
DTI at work:
We’ll use current (Aug 2018) FHA limits in our examples, with a median household income of $59k. This means your max ratio is 31/43 for FHA (generally, this isn’t always true, it varies lender to lender). For the sake of argument we’ll use the following for debts: $300/mo car payment, $280/mo student loans, $120/mo credit card minimums.
- Front-End: ($59,000/12) $4,916 x .31 = $1,524/mo max mortgage
- Back-end: ($59,000/12) $4,916 x .43 = $2,113/mo max mortgage + debts
We already know we have $700 a month in recurring debt payments, so we can’t use the max front-end (max allowable back-end only lets us have $589 a month in debt payments). So we need to make sure we adjust our mortgage payment down to $1,413 ($2,113-$700) when shopping for a house.
ALWAYS consult a financial advisor before assuming how much house you can afford.
Of course a lot of this is oversimplification, especially with the DTI. But you can get a basic overview of how the mortgage structured. Using DTI, you can get a rough idea on how much house you can actually qualify for. Keep in mind, mortgage lenders are using maximums based on what THEY think you can handle. You need to be honest with yourself and make sure that’s actually what you can do.
ALWAYS speak to a financial advisor before talking to a mortgage lender, and ALWAYS seek out an experienced lender with great ratings before you move forward with your loan. If all else fails, give yourself some wiggle room. Using the example of $1,413 above, you may be better off dropping your expectations down to the $1,200 range to be safe. Just because a lender tells someone making $59k a year they can afford a $300k house doesn’t mean they actually can.