What’s Included in Your Mortgage Payment
By Mark Nash
- The four components of a mortgage payment
- When private mortgage insurance is required
- What is the monthly payment you can afford?
Thanks to a nifty insider acronym, courtesy of the mortgage industry, you can easily remember the four basic components of a mortgage loan: It’s PITI, and it stands for principal, interest, taxes and insurance.
Let’s break down the P and I in PITI first: Your monthly mortgage payment includes two parts, the principal and interest payment. The principal is the actual amount you borrowed from the lender. Every time you make a mortgage payment, your loan balance decreases, while your home equity — the portion of your home you own — increases.
The interest is the amount a lender charges you for borrowing the money to buy the home. Initially, the largest part of your mortgage payment is applied against the interest you owe. As your mortgage matures over time, more of your monthly payment goes toward paying off the principal. Your mortgage rate can change periodically if you have an adjustable-rate mortgage. It can also change if you renegotiate your mortgage or make a lump payment to lower the principal.
Property taxes and insurance
Taxes and insurance make up the “T” and the “I” in PITI. Depending on the size of your down payment, you will have to pay your real estate taxes to the lender as part of the mortgage payment. The lender passes these on to county government to pay for schools, roads and other community services. Once you have paid off a certain percentage of your principal, lenders will allow you to pay your own property taxes. But you should keep in mind that real estate taxes take a hefty bite out of your total mortgage payment, and the tax rates can fluctuate significantly, especially if you plan to move into an area that’s quickly gentrifying. Do your research before making an offer on a house.
The fourth component of your payment is homeowner’s insurance, which may be collected by your lender and paid to your insurance company. Homeowner’s insurance protects your home and property against fire or other damage. You may need extra coverage for other risks, depending on where you live.
In case the lender considers you a risky client, you may also be required to have private mortgage insurance (PMI) in order to secure your mortgage. The PMI protects the lender from bankruptcy in case you can no longer make your payments. Once your mortgage payments amount to 20 percent of equity in your home, you may be able to cancel the PMI. Be aware that monthly premiums for PMIs will pack a punch to your mortgage payments and may influence how much principal you may borrow.
Understanding the financial calculations mortgage lenders must make in order to decide on the conditions of your loan should help you get a firm grip on your reality, rather than blaming the mortgage lender for being mean if he rejects you. Nothing will impress a mortgage lender more than a customer who understands and can master the calculations to determine the terms and amount of the home loan offered to you.
Down payments and LTV ratio
As a rule, try to make the highest down payment on the home you can afford. A small down payment will likely spike your mortgage interest rate. Your loan officer will calculate your loan-to-value (LTV) ratio as a borrower during the mortgage-approval process. That’s the mortgage amount you need, divided by the market value of your prospective home.
If you can only make a $20,000 down payment on a $180,000 home, you’ll carry an LTV of 90 percent, since the lender assumes 90 percent of the purchasing costs for the home. That means that it will take you longer and cost you more, due to the high interest, to pay off your loan and own your home.
One of the most important calculations lenders make to approve a mortgage application, is your debt-to income ratio. They add up all your monthly payments, from personal expenses to insurance, bill and credit card payments, and divide them by your gross monthly income. Dividing your total debt by your total income yields the percentage, or the portion of your income that your debt constitutes. The smaller that percentage, the higher the likelihood you’ll qualify for a mortgage with very good terms. Most experts recommend your debt-to-income ratio should be below 40 percent, so you can comfortably afford paying a monthly mortgage.
Front and back ratios
It gets a little more complicated: Lenders compare two of your debt-to-income ratios, a “front” ratio and a “back’ ratio. The front ratio consists of all your monthly money that exclusively goes towards paying your housing costs (including principal, interest, taxes, insurance, assessment fees and mortgage insurance), divided by your total income. The back ratio adds to those housing costs your monthly consumer debts, such as car payments, credit card debt, other loans, etc. and divides them once again by your gross monthly income. The purpose is to compare both results to one another in order to evaluate your financial situation.
Mortgage experts say a healthy front-to-back ratio is about 33/38. That means that a borrower’s housing costs should consume no more than 33 percent of his or her monthly income. Adding the borrower’s monthly consumer debt to the housing costs should amount to a maximum of 38 percent of monthly income, in order to meet sound mortgage payment requirements.
It’s no secret that homeowners who took out mortgages they couldn’t afford were in part responsible for the housing crisis that began in 2007. Spare yourself the hardship of foreclosure. Don’t agree to a “surprisingly generous” loan offer you think you can handle, if the monthly payments will leave you with little gas, medicine or grocery money, or a safety net in case of job loss. Rationally evaluating your debt-to-income ratio can help prevent the purchase of your dream home from turning into an endless nightmare.
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