I PITI The Fool….

You’ve probably come across the PITI at some point. For the uninitiated, this refers to four of the very common recurring costs of real estate ownership: principal, interest, taxes, and insurance.

Obviously, these four costs are not universal: properties without associated debt won’t have a principal or interest cost. Nor are they comprehensive: many other types of cost (for instance, repairs and property management fees) certainly abound.

But these four costs are generally lumped together for the a few reasons. First, they’re common—relatively few instances of real estate are owned without these costs. Second, they’re rather predictable, at least in the near term. Principal and interest (in aggregate) are generally a fixed monthly cost (for the duration of the mortgage), and taxes and insurance costs usually (but not always) are due at fixed intervals and gradually rise with time. Third, these costs are the ones lenders are most concerned with, because they provide for the security of the property and its ownership. This is why banks often offer or insist upon regular contributions to one or more escrow accounts specifically for such liabilities. Fourth, they often account for the majority of costs of ownership, especially over any long period of time.

Between the second and fourth reasons above, PITI can be an efficient way to assess costs of a given property, to model cash flow, and in turn to help determine whether an potential investment is a good one (and of course help to hone in on a price that would make it a good investment).

But let’s get unorthodox for a moment: the “P” shouldn’t really be part of PITI. Or at the very least, it doesn’t really fit with the others. All of the others—interest, taxes, and insurance—are sunk costs that go to pay the bank, the government, and the insurer (respectively) for the service they are providing in support of your real estate ownership. Principal, on the other hand, is money you are more or less setting aside for yourself (assuming the property at least maintains its value).

This is an important distinction. We choose investments based on their ability to yield cash flow that covers PITI and any/all other expenses, at least over the long run. But a property whose income covers ITI and other expenses, while forcing me to “pay” some of the monthly “P”, is not necessarily bad, especially if the property is appreciating at a healthy rate, or if I have a shorter amortization (and therefore accelerated repayment schedule). In these circumstances, and especially when deals are tough to find, I encourage people to view the “P” (principal, just to be clear) with a bit more flexibility as to how that will be sourced. In the end, however, it is crucial not to assume an investment without the ability to cover that portion of the costs, whether from the cash flow or from other sources (for example, your savings or W2 income). That’s where trouble will come…