Mortgage: Understanding Escrow Accounts
At closing, you will be required to deposit real estate taxes and insurance premiums into an escrow account (sometimes called an impound account). An escrow account ensures that the taxes and insurance will be paid, and on time. This protects the lender from tax liens and uninsured losses that the borrower can't repay.
The federal Real Estate Settlement Act limits the amount lenders can require in escrow to a maximum of two months' payments. Escrow assessments and adjustments are generally made annually.
How escrow accounts are managed
The amount in the escrow account varies during the year due to tax assessments and insurance premium adjustments. The lender typically will cover any shortfalls until it can adjust your monthly payment to make up for tax hikes and premium increases. Your monthly mortgage payment will fluctuate from year to year, even on long-term fixed-rate loans.
Can I avoid escrow?
Yes. Some lenders allow you to pay your own property taxes and home insurance premiums, especially if your loan-to-value ratio is below 80 percent. But don't be surprised if the lender boosts your interest rate to compensate for the additional risk it is assuming.
Once an escrow requirement is in place, it can be difficult to persuade a lender to cancel it. If your loan is sold, as is common, and there is nothing in the lending agreement that provides for cancellation of the escrow requirement, you'll have to live with the decision of your new mortgage servicer.
Let your escrow grow for you, not your lender
Are you a do-it-yourselfer who wants to make a few extra bucks? Or would extra money lying around burn a hole in your pocket and leave you without enough cash to pay tax and insurance bills?
Depending on the answers to those and other questions, you may be someone who can do without a mortgage escrow account. Lenders require high-risk borrowers to establish escrow accounts -- and suggest lower-risk customers do, too -- to ensure they can pay real estate tax and homeowners' insurance bills when they come due.
But many consumers have the option of foregoing them and saving money for those bills on their own.
If you've got what it takes
Financially savvy shoppers can earn a few extra dollars in interest, save money on taxes and avoid lender snafus by doing so. But forgetful consumers who can't budget wisely should leave the work to their lenders.
"A lot of people just don't want to worry about something like this," says Frances Graham, extension housing specialist at Mississippi State University in Starkville, Miss. "They don't want to have to worry about insurance being paid and when it's due and there's something to be said for someone else handling it.
"But it depends upon the individual," she adds. Responsible homeowners "have the opportunity to earn a little interest if they put their money aside in a special account that they handle and that they save regularly in."
Escrow accounts (also called "impound" or "reserve" accounts in different parts of the country) offer customers the chance to save money incrementally for big bills associated with homeownership. Mortgage lenders maintain these accounts on behalf of borrowers, who make payments into them each month along with their regular principal and interest payments. Lenders keep the money from those payments on deposit, then disburse it to local governments and insurance companies when those entities send out their bills. That usually happens twice a year for taxes and once annually for insurance, though billing frequency varies.
Lenders want their borrowers to establish escrow accounts for a couple of reasons. For one thing, they make money off of them. Most states don't require lenders to pay borrowers any interest on the money they hold on their behalf. Lenders can therefore "play the float," or earn money off the cash borrowers send in but that they don't have to pay to governments and insurance companies for a couple of months. Secondary market buyers who purchase mortgages from banks and other lenders pay more for loans with escrow accounts attached to them, too. So by convincing borrowers to establish them, they can pad their profits a bit.
Benefits for both parties
Escrow accounts help lenders avoid problems that can arise if taxes and insurance go unpaid, too.
"The only lien that takes a higher priority than a first mortgage lien is a tax lien. That supersedes a mortgage note. Lenders prize dearly their primary mortgage liens and they're not going to give them up or let anything happen without a fight," says Ilyce Glink, author of 100 Questions Every First-Time Home Buyer Should Ask. "Also, they want to make sure the property is insured. If it's not insured and there's a catastrophe, the lender can end up losing money."
Escrow accounts provide benefits for borrowers, too. In essence, they work like automatic, forced savings plans. By paying a smaller portion of their taxes and insurance every month, homeowners can avoid having big bills come due at a time when cash is short. Simplicity plays a role as well. Customers with escrow accounts don't have to worry about tracking tax and insurance bills because their lenders do it for them. That can come in handy for people who just want to get a mortgage and forget about it.
"Knowing what I do and having had a number of mortgages myself, I've had it both ways and I cannot think of an advantage of not having an escrow account," says Rich Bennion, executive vice president at HomeStreet Bank in Seattle. "It's so convenient. It's kind of like having an automatic payment out of your checking account -- you never have to worry about it."
Most customers agree, he adds. Out of roughly 40,000 mortgages serviced by the bank, 90 percent have escrow accounts attached to them.
"People are much better off having the reserve accounts just for ease and convenience."
But that convenience comes with a price that many borrowers don't have to pay.
Whose money is it, anyway?
By telling their lenders before closing that they don't want to establish escrow accounts, they can take charge of their finances themselves.
That lets them earn discounts -- such as those offered by tax authorities to people who pay early -- that might not be available otherwise. It also prevents lender servicing errors, such as missed tax payments, from cropping up.
"They may be late making the payments. The account gets sold. Taxes don't get paid. The buyer gets a notice of default of unpaid taxes and all hell breaks out," says Glink.
By socking away the money they would otherwise have to send to their escrow accounts, consumers can pocket some interest, too. Plus, they avoid the escrow account setup fees some lenders charge.
"Say you've got $10,000 in taxes because you've got a large house," Glink says. "That's no small change in terms of interest over the course of a year."
Not everyone can waive escrow accounts, though. Most lenders prevent borrowers with small down payments from doing so. The loan-to-value threshold below which they can be waived varies by lender, but experts say it typically ranges from 80 percent to 65 percent.
Some lenders charge a fee for the "privilege," too. That covers two things -- the increased risk to the lender that taxes and insurance won't be paid and the loss of income resulting from the fact that non-escrow loans are worth less in the secondary market. The charge can be a flat fee of, say, $250 to $500 or a percentage of the loan amount. At HomeStreet, for instance, borrowers can waive escrow below 80 percent LTV. But they typically have to pay a quarter-point, or one-fourth of a percentage point of their loan amounts, to do so.
If the fees for avoiding escrow would outweigh the potential earnings from interest, borrowers should either find another lender with cheaper fees or just accept the escrow account. Borrowers without a lot of budgeting discipline should consider letting someone else worry about payments, too.
But for prospective home buyers who want to avoid servicing screw-ups and who have large enough tax and insurance bills that saving money for them on their own is sufficiently profitable, waiving escrow makes sense.
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