The journey to homeownership is an exciting one, but it can also be intimidating. It’s probably your largest purchase to date, and there may be terminology you’re unfamiliar with. If you’re looking to buy a home, you probably have seen some mortgage-related terms, sometimes abbreviated as PITI. These terms represent the four standard components that make up your monthly mortgage payment: principal, interest, taxes and insurance.
These mortgage components work in both the borrower and lender’s favor because it helps you determine if you can afford a house and helps the lenders decide if you’re a good risk for their loan. By understanding these key parts of a mortgage payment, you’re on the right track to paying off your future home.
The Four Parts of Your Mortgage Payment
The mortgage principal is the amount you owe your lenders. For example, if your house costs $400,000, and you made a down payment of $80,000, then the principal owed is $320,000. In the early years of your loan term, the amount you pay toward the principal is typically low because your payments go toward interest, but it increases over time as the ratio of principal to interest changes.
We saw record-low mortgage interest rates in recent years, but these rates are in constant flux. You can think of interest as the price you pay for borrowing money, and your early mortgage payments will be dedicated to paying off the interest while the loan balance is at its highest.
From the example above, let’s say you locked in a 5.5% interest rate on a 30-year mortgage. Each month, your interest is added to the principal, tax and insurance amounts. In the first month, you’d first pay $1,467 in interest, and the amount would gradually decrease as more payments are completed.
Now that we’ve covered the first two terms, we’ll discuss how property taxes are built into your monthly mortgage payment. Your property tax will alter over time, and these taxes depend on factors like where you live and the changing value of your home. Property taxes go toward funding important public services, such as sending children to school or keeping the local fire department up and running.
Property taxes are assessed once a year, but out of convenience, your lender can take care of paying your property tax bill for you. To do so, your large annual sum is broken up into 12 and included in your monthly mortgage payment. The funds are then held in an escrow account until they are due.
The last component is insurance, and there are two main types of insurance that may be included in your monthly mortgage payment:
- Homeowners insurance
- Homeowners insurance protects you from the unexpected such as a fire, break-in or weather damage. Lenders often require homeowners insurance, and they encourage you to pay for additional coverage if you live in an area prone to natural disasters. Just like your taxes, the insurance payments can be broken up into 12 parts and included in your monthly payment.
- Private mortgage insurance (PMI)
- Many people aim to put down 20% when purchasing a home, and private mortgage insurance is the reason why. PMI is required for most people who purchase a house with a down payment of less than 20%. This type of insurance protects the lender if you default on your mortgage and your house goes into foreclosure. However, if you build up 20% home equity, you can get rid of PMI and lower your total principal, interest, taxes and insurance payment.It’s also important to note that if your mortgage is backed by the Federal Housing Administration (FHA), then you are required to get FHA mortgage insurance whether or not you put 20% down. These loans include a mortgage insurance premium (MIP) that requires a large initial payment, in addition to monthly payments.
In short, these four components make up your mortgage and help you see if you can afford a home. To ensure you’re a good fit for a loan, lenders will consider other factors such as your debt-to-income ratio and your gross monthly income in comparison to your potential payment.
Although mortgages can be daunting for first-time home buyers, familiarizing yourself with all of the aspects that make up a monthly payment can set you onto a successful path to homeownership.