While you may be thinking mainly about paying your biggest expense as a new homeowner — the principal and interest on your mortgage — you’ll need to pay property taxes and homeowner’s insurance premiums, too. Some homebuyers also have mortgage insurance and homeowner association payments.
Many of those bills can be included in an escrow account, also known as an impound account in some geographic regions, managed by your lender or loan servicer. Generally, when you have an escrow account, your lender will find out how much you’ll owe for the year for property taxes and homeowner’s insurance.
Mortgage insurance premiums can also be paid through an escrow account. Then, that total will be divided into 12 payments that are included in your monthly mortgage bill. Lenders usually add a little extra cushion to what they collect to make sure they have enough funds available when the bills are due.
Your lender will keep those funds in a separate account and pay them when your taxes and insurance bills are due. Lenders often prefer to handle those bills in this way to make sure they’re being paid on time and in full. This protects the lender’s investment in your home and protects you.
While most homeowners have an escrow account with their lender for automatic payments for their taxes and insurance, it’s not always mandatory. If you have a choice, you may want to look at the pros and cons of an escrow account before deciding how you prefer to handle those payments. You can even request an escrow or impound account if one isn’t offered — or you can opt out in some cases.
“Some loan programs, such as FHA, require you to always impound your taxes and home insurance,” says Christy Bunce, president of New American Funding, a lender based in Tustin, California. “VA loans require you to have at least your taxes impounded. In most states, on conventional loans, if your loan-to-value is over 80 percent (or you make a down payment of less than 20 percent), impounding your taxes and insurance is required. In California, you must impound your taxes and insurance for any mortgage with a loan-to-value of 90 percent and over.”
USDA Rural Development housing loans also require escrow accounts for the entire loan term.
If you have more than 20 percent equity in your home or make a down payment of at least 20 percent, you may be able to choose to skip an escrow account and act as your own banker for all your housing payments, says Erica Davis, branch manager of Guild Mortgage in Myrtle Beach, South Carolina.
“However, this option does put the responsibility of payments completely on you,” she adds.
Why Opt Out of an Escrow Account?
Some people prefer to keep the money that their lender would be collecting for taxes and insurance in their own bank account for several reasons, including the ability to earn interest on the money as it accumulates, says Bunce.
In most cases, mortgage escrow accounts don’t earn interest. However, 15 states require lenders to pay interest on escrow accounts: Alaska, California, Connecticut, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New York, Oregon, Rhode Island, Utah, Vermont, and Wisconsin.
“Some people prefer to handle those payments themselves so that they are more aware of how much they’re paying for each thing separately,” Bunce says. “Combining these payments for taxes and insurance with a monthly mortgage payment increases that mortgage payment. It also allows it to fluctuate when taxes or your insurance premiums rise or fall.”
Even when you have a fixed-rate loan, your monthly payment could be adjusted annually to manage those tax and insurance payments.
When you first buy a home, you may be required to pay two to three months’ worth of taxes and insurance to establish an escrow account as part of your closing costs. If you ask for an escrow account waiver, that may save you money at closing. However, you may still be required to pay at least some of those costs in advance even without an escrow account.
“If you choose to pay taxes and insurance yourself, it can be a good way to learn more about the process and build your savings,” Davis says. “There are some financial benefits associated with managing these funds yourself, like obtaining and maintaining higher interest rates on savings accounts.”
Disadvantages of Canceling an Escrow Account
Still, there are several reasons to consider keeping an escrow account even if you could close it.
Using an escrow account can break large payments like taxes into smaller monthly payments, which can be helpful for budgeting, Bunce says. Without an escrow account, you could be making large lump sum payments annually, semiannually, or quarterly.
“When you set up an escrow account you are putting the responsibility of paying your taxes and homeowner’s insurance in the hands of a third party,” says Bunce. “Some people prefer this because it allows them to automate the payment process and makes them feel more secure.”
The automated system doesn’t require you to keep track of due dates for your insurance premiums and property tax bills.
“The risk with managing paying those payments themselves is those payments can be quite large depending on the state and property value,” says Bunce. “With an impound account, it is automatically saved and paid for. If a customer does not pay their taxes, the county could put a lien on their home. If they do not pay their insurance premium, they could be forced to take ‘force-placed’ insurance by their lender, which is very expensive.”
It definitely takes extra work to manage your own bills without an escrow account, Davis says.
“You must also ensure that you have enough funds available in time for when bills are due, as skipping a payment could lead to foreclosure of your property,” Davis says. “If something happens and payments aren’t made, then it could affect your credit score, which will impact any future mortgage loans [or other credit applications] down the line.”
Splitting Your Payments
If you’re not sure you want to manage all of your mandatory payments on your own but don’t want your lender to collect so much money through an escrow account, you may be able to have just some bills paid that way. This depends on the type of escrow account your lender uses, Davis says.
“Each lender and loan product is different, so it’s best to check with your servicer if you want to split your payments,” says Bunce.
It’s possible your lender would allow you to set up an escrow account just for your property taxes, Davis says, but some accounts require your insurance payments to be included.
“Ultimately, it all depends on your needs and preferences when it comes to setting up an escrow account. Speak with your lender to determine the best solution for you,” Davis says.
Changing Your Mind About Escrow Accounts
The good news is that you do have some flexibility about escrow accounts.
“If you didn’t set up an escrow account with your lender when you first chose a mortgage loan, you’re not stuck without one forever,” Davis says. “You can always inquire about setting one up later, and in some cases, it may even be beneficial to do so.”
On the other hand, as long as your mortgage loan is in good standing, your loan program allows it, and you have at least 20 percent in home equity, you can request an impound account waiver, says Bunce.
As a homeowner, you can discuss your options with your lender and consider what works best for your budget. If you’re excellent at paying bills on time and your taxes and insurance are substantial payments, it may be a smart move to pay them on your own so you have more control over the funds until they are due. If you occasionally miss due dates and are juggling too many expenses, though, it may be wiser to let your lender manage these extremely important financial obligations for you and spread out the costs over a full year.
Michele Lerner is an award-winning freelance writer, editor and author who has been writing about real estate, personal finance and business topics for more than two decades.