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What Is PITI and Why Does It Matter When Applying for a Mortgage?

Christy Bieber, The Motley Fool

If you're shopping for a mortgage, you'll hear the term PITI. But what does PITI mean, and why does it matter? 
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A couple looking at a home with a realtor.

Shopping for a mortgage can be confusing because lots of unfamiliar words are often used by your lender or found in financial paperwork. Early on in the process, one of the words you're likely to hear is PITI.

PITI is actually an acronym. It stands for principal, interest, taxes, and insurance. It's necessary to calculate PITI for every potential mortgage loan as this calculation can determine whether or not you'll be given the financing you need.

What is PITI?

PITI accounts for the total costs you have to pay for your housing.

When you're a homeowner, you have to pay back your mortgage loan over a set period of time, such as 15 years or 30 years. You're charged a certain amount of money each month to make sure you can repay the loan on schedule. The amount you're charged could be a fixed amount, if you have a fixed-rate loan. Or it could fluctuate if you have a variable-rate loan and your rate changes.

The amount you're charged to get your loan paid off is calculated based on the interest you must pay plus the portion of principal you have to pay to get the balance to $0 by the end of the term. The “P” and “I” in PITI stand for Principal and Interest.

But, your mortgage isn't the only cost you incur. You also have to pay real estate or property taxes. The amount of tax you owe is based on the tax rate where you live and the appraised value of your property.  

You may be required to make monthly payments towards your tax bill that are included in your mortgage payment. Your lender then puts this money into an escrow account and uses the funds to pay the tax bill when it's due. If you're able to waive escrow, you don't have to pay a portion of the tax bill to your lender each month. But the monthly cost of taxes is still factored in when determining your housing costs. Taxes are the “T” in PITI.

Finally, you have to pay homeowner's insurance to protect your home, which lenders require because the home is the collateral that secures the loan. If you put down less than a 20% down payment on your home, you're also required to pay private mortgage insurance (PMI). PMI protects the lender in case you default by making sure the lender is paid back in full.

Insurance payments may need to be paid into escrow on a monthly basis, and the lender would pay the insurer when the bill is due. If you've waived escrow, you'd be responsible for paying the insurance cost yourself but the monthly amount due is still factored in. The insurance payments are the other “I” in PITI.

Finally, if you're required to pay homeowner's insurance fees, lenders may factor those into PITI as well.

Why does PITI matter?

PITI matters because lenders use this number when determining how much you are allowed to borrow. Mortgage lenders don't just loan you an unlimited amount of money when you want to buy a home. They want to make sure you're able to afford to pay back your loan.

Lenders look at your debt-to-income ratio as one of the key factors in deciding if you're likely to be able to pay back what you borrow. Your debt-to-income ratio, or DTI, is the amount of debt you have relative to income. There's both a front-end ratio and a back-end ratio that lenders will assess -- and both consider PITI in the calculations.

The front-end ratio simply compares PITI to your gross monthly income, not any of your other debts. So, if your principal payment and interest payment on the mortgage, plus your taxes and insurance, added up to $1,200 per month, this is the number that would be used to determine your ratio. If your gross monthly income is $5,000 per month, you'd divide $1,200 by $5,000 and your debt-to-income ratio would be 24%.

Lenders typically want to see a front-end debt-to-income ratio of around 28% at most. If your front-end ratio is higher than that, you may not be approved for a loan or your interest rate might be higher because you present a bigger risk.

The back-end ratio takes into account both PITI and all of your other monthly debt obligations. So, if you owe student loans, a car payment, and a credit card payment, those monthly payments are also factored in when calculating the back-end ratio.

If your PITI was $1,200 and your other debt payments added up to $600 per month, your back-end ratio would equal $1,800 divided by $5,000 or 36%. Typically banks prefer your back-end ratio to be 36% or lower, although some lenders allow you to go as high as 43%.  

If either your front-end or back-end ratios are too high, you may need to buy a less expensive house so you can borrow less and your PITI will be lower. Or, you could pay down other debt to get a better back-end ratio and increase your chances of loan approval.

PITI could also be used to calculate reserve requirements

In some cases, mortgage lenders will require you to have certain cash reserves before you can be approved for a loan. This just means you must show you have a certain amount of money saved in case you experience an interruption in income. Mortgage lenders put reserve requirements in place to ensure you are able to keep paying your mortgage bills even if you lose your income for a while.

Reserve requirements vary by lender, but two months of PITI is common. So, if your PITI was $1,200, the lender would require you to show you have $2,400 in a deposit account before they'd approve your loan.

You can calculate PITI when shopping for a home

There's no sense in falling in love with a home you can't afford. To avoid this, you can calculate PITI for any home you're considering. You just need to know the taxes, estimated insurance costs, and what your likely mortgage payment would be. Once you know this number, you can both determine if you're likely to be approved for a loan based on your debt-to-income ratio... and you can determine if your housing payment will be affordable for you.

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