Perhaps the most important question to ask yourself when it comes to buying your home is: how does this purchase fit into my overall finances?
Since buying a home is likely the largest purchase most of us will make, you need to consider several things when it comes to buying a home. It’s not just the initial cost of a down payment, but you also need to factor in all the expenses associated with purchasing, maintaining, and keeping the home. Your monthly mortgage, fees, taxes, insurance, home owner dues (i.e., HOA fees), and other associated costs, are all line items on the homebuying bill. And many of these expenses are ongoing.
Principle, Interest, Taxes, and Insurance (PITI)
One of the most important financial considerations related to your home buying journey is referred to as PITI, which stands for the sum of monthly principal, interest, taxes and insurance. This is usually calculated on a monthly basis and your lender will compare it to your monthly gross income to see if you are a viable candidate for a mortgage loan (often called the debt-to-income ratio). In the event that you might lose your income or lack enough equity or other assets, your lender may require special considerations, such as two months of PITI.
So what exactly goes into PITI? A very high-level overview of its components include:
- Principal – This is the amount of your loan, so it is likely the cost of your home minus your down payment.
- Interest – Just like the majority of other loans, the interest is the amount the lender charges you for borrowing money.
- Taxes – Real Estate tax rates vary significantly from area to area, so you should figure out just how much of your PITI goes to taxes.
- Insurance – Your lender may require homeowner’s insurance as part of your PITI.
Another requirement from your lender that can be included in your monthly PITI is Private Mortgage Insurance (PMI). If you put down less than 20% for a down payment – even with good credit – then your lender may find your smaller down payment as a higher chance of default, thus requiring PMI. Though PMI payments can be canceled once you gain 20% equity in your home, building up to 20% can mean years of pricey PMI payments
Keep in mind that PITI may just account for just some of your monthly expenses when owning a home. Depending on where you live and how you are paying for your home, there may be additional costs built in. And the components that make up PITI are very broadly defined here; there is often more complexity that goes into each part of PITI.
PITI & Escrow
While many of us have heard of “escrow” when it comes to home buying (and other financial transactions), one thing that is less known is that PITI is also known by lenders as your “escrow account.” Your monthly PITI payments go into your escrow account and your funds are disbursed to the lender for the interest, principal, property insurance (and for some, PMI), to the county for property taxes when they come due, and your insurance carrier for your homeowner’s insurance.
For many first-time home owners, an escrow account is mandatory, and in many ways can be very useful. For instance, when the time comes for making the payments for real estate taxes, many find it easier to pay them monthly rather than face a large bill due at one time (or twice depending on your taxing jurisdiction.)
PITI & The 28% Rule
When it comes to calculating what you can afford regarding your PITI, a good rule of thumbs is that 28% of your gross monthly income is the maximum monthly cash outflow for costs associated with your house payments.
The 28% amount is calculated by taking the principal and interest of your monthly mortgage payment and adding one-twelfth of your annual real estate taxes (i.e., one month of real estate taxes), as well as one-twelfth of your annual homeowner’s insurance premium (i.e., one month of your annual homeowner’s insurance) and one-twelfth of any annual association fees (i.e., one month of your annual HOA fees). Then divide this by your gross monthly income.
One variation of this is the 36% rule, which is calculated by taking your monthly PITI as calculated above, and then adding any homeowners-association dues or condo fees, credit cards, car loans, student loans and any other personal loans. Then divide this by your gross monthly income.
So why the magic number of 28/36? It’s a “rule of thumb” for determining the amount of debt that is generally recommended to be taken on by an individual or household so that you can maintain enough cash to afford other living expenses (food, car payments, clothing, entertainment, etc.), while still saving for retirement.
PITI is just one of the many financial considerations to think of when making such a large financial commitment. A financial advisor can help you understand your PITI more thoroughly, as well as help you determine whether buying a home fits into your overall financial strategy.
To learn more, read our free Personal Capital First-Time Home Buyer’s Guide.
Disclaimer: The information presented above is for informational purposes only and does not constitute a complete description of our investment services or performance. No part of this site nor the links contained therein is a solicitation or offer to sell securities or investment advisory services. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.
Brian Wainscoat, CPA
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