The Four Components of PITI
Definition: PITI is an acronym that stands for principal, interest, taxes and insurance. A borrower generally pays back the principal over 30 years, which includes interest. Your own mortgage payment may not contain a provision for paying taxes and insurance to the lender, but all PITI payment plans do. To determine an owner's monthly taxes and insurance prorations, the annual figure is divided by 12 and rounded, depending on when those payments are due.
All home owners with a mortgage pay taxes and insurance, although not everybody lets the lender pay their taxes and insurance. Owners who buy into a planned unit development or a townhome / condo, also pay a homeowner association fee, which may or may not include insurance.
The Four Components of PITI
Let's begin by breaking down the definition of PITI.
PRINCIPAL. The first letter is P which does not stand for pool. It is for principal. It is not spelled principle, which is a different word, so remember that. Principal is the amount of the mortgage payment that is paid every month, and some would say it's the most important portion of the payment because that amount reduces the unpaid balance of your mortgage. Paying interest, for example, does not reduce the principal portion of your mortgage.
INTEREST. Which brings us to the second letter, which is I for mortgage interest. Interest is one way the lender makes a profit on your loan.
The lender also collects loan points upfront which adds to its profit. But the interest is the largest portion of profit. The way amortization is structured for a 30-year loan, the largest portion of a monthly payment is paid to interest, with only a small fraction of the payment applying to principal.
As time goes on, and payments are made over a period of years, when you get closer to the end of the amortization period, a larger portion of the monthly payment is paid to principal with a smaller amount applying toward interest. For example, a $200,000 loan at 5% interest for 30 years = $1,073.64 principal and interest. The first payment breaks down to $833.33 interest and $240.31 toward principal.
This is derived by taking $200,000 x 5%, which equals 10,000, representing first-year interest, and dividing that number by 12, for the number of months in a year, which = $833.33. Subtract $833.33 from the PI of $1,073.64, and the result is $240.31 of principal.
TAXES. The third letter is T for taxes, which means property taxes. Every county has its own taxation system. In addition, the taxes can change from year to year, and sometimes properties are reassessed upon resale, so you cannot always count on the existing taxes remaining the same. You should check with your county assessor's office to find information on property taxes.
In Sacramento, California, for example, we often use 1.25% of the sales price to calculate the approximate amount of property taxes for estimation purposes. Our property taxes involve other taxes for things like schools, street lighting, special assessments and Mello Roos.
Mello Roos is a special tax passed on to homeowners by many builders of new homes constructed after 1982.
Depending on when your next tax statement is due will depend on how much the lender will withhold for setting up a tax account. You can figure on anywhere from 2 months to 6 months will be collected in advance as part of your closing costs.
INSURANCE. The last letter is I for insurance. If you have a homeowner's association, generally the HOA maintains a blanket insurance policy for the complex, which is paid from your HOA dues. However, you may still want to maintain, and your lender might require, an insurance policy on the contents and interior of your unit.
If you are buying a single-family home, you will need to obtain a homeowner's insurance policy. Do not wait to shop around until the last minute, especially if you're buying an older home because some insurance companies do not insure older homes.
The lender will include a portion of your payment to pay for the next insurance policy but the first payment for your policy is due in full at closing.
At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.