When you purchase a home, your final monthly home payment is made up of more than just the purchase price of your home. It has 4 distinct components often referred to as PITI—principal, interest, taxes, and insurance.
Principal
The principal is the original amount of money loaned to you by the bank. If you got a loan for $125,000, then the principal amount of the loan is $125,000. As you pay your balance down, the principal amount becomes the amount that you currently owe, excluding any interest.
Loans are created in such a way that your principal payments start out small and your interest payments start out large. As you pay off your loan, this balance tips. By the end of your loan, you will be making payments that consist primarily of principal repayment.
Interest
Interest is what the banks charge you to use their money. Interest rates are a big factor in determining the size of your mortgage payment. The higher your interest rate, the higher your payment will be. Interest rates often determine just how much a borrower can afford. For instance, if you were to borrow $100,000 at 5% for 30 years, your interest plus principal payment would be $537 a month. If, however, interest rates were to go up to 9%, that payment would balloon to $805.
Taxes
The next element that makes up your mortgage payment is property taxes. Taxes can be assessed by your city and/or county. The affected government agencies calculate your home’s worth and collect taxes based on the worth of your home. These taxes are used to fund local services such as police, garbage disposal, fire departments, and education.
Although taxes are typically only due once or twice a year, your monthly mortgage will have a tax payment component. Your lender will put your tax payment into a special fund called an escrow account until it is time to make the full payment to the government agency.
Changing taxes can change the amount you pay for your monthly mortgage payment. If taxes on your property go up, your lender will recalculate your monthly mortgage payment so that you have enough in escrow at the end of the year to pay your property taxes. If your taxes are lowered, your monthly payment will decrease.
Insurance
There are two kinds of insurance that can be included in your mortgage payment. The first is called homeowner’s insurance (HOI), hazard insurance, or property insurance. HOI covers your home in case it is damaged due to a hazard such as fire or tornado. It also can cover the content of your home and additional expenses to live outside of your home while your home is being repaired. Finally, it provides protection for you in case someone has an accident in your home. The cost of HOI depends upon the replacement cost of your home, the contents within your home, and the amount of liability insurance coverage you seek. HOI costs are also higher if you include special insurance for things like flooding or earthquakes. HOI premiums can change yearly, thus affecting your monthly mortgage payments. It is in your best interest to review your HOI each year to see if the insurance covers your needs adequately and at the best rate.
The second type of coverage is called Private Mortgage Insurance (PMI). PMI is often required by lenders if you made a down payment of less than 20%. PMI provides protection against foreclosure, so lenders feel more comfortable offering loans with a lower down payment. PMI rates vary, depending upon the loan. They usually range from 0.3 to 1.15 percent of the original loan amount per year. Your PMI will remain the same throughout the length of the loan, so this portion of your monthly payment will remain the same. Keep in mind that many lenders will allow you to remove the PMI once you have reached at least 20% equity in your home. When this happens, your monthly payment will drop. Just as with your tax payments, your lender will put your insurance premium payments in a special escrow account and pay the premiums when they come due.
