There are all kinds of “escrow” you may encounter as a homebuyer.
For example, your builder should place your deposit money into a separate escrow account, where it will be safely held until it is applied to your down payment at closing or returned to you if you should change your mind for some reason.
The escrow most new homebuyers fret over is the account held by their lenders — or more likely the loan’s “servicer,” which is the company that will administer your loan.
How Does An Escrow Account Work?
An escrow account is set up to collect your payments for property taxes, homeowners insurance and possibly other items, in equal amounts over a 12-month period, to be paid on your behalf when those bills come due, according to the Consumer Financial Protection Bureau. The question most people have is why can’t they pay these bills on their own? And the answer is you can — if your lender agrees.
But the choice is entirely up to the lender, or more likely, the investor that ultimately buys your loan. And since investors want to make absolutely sure those bills are paid, they almost always require escrow. After all, if your property taxes aren’t paid, it will result in a lien against the house, a lien that supersedes theirs. And if your insurance isn’t up to date and you have a fire that results in a major loss, there will be no protection to cover the cost of rebuilding your place, which serves as the underlying collateral for your loan.
For novice homebuyers, a little explanation: Lenders fund mortgages, but they typically sell their loans shortly after closing to investors on the secondary market. Those investors could be another bank, a pension fund or even a foreign investment group, among several other entities. But whoever ends up with your loan usually hires a third-party servicing company to collect the payments and disperse the funds. For our purposes, from here on out, it is easiest to use the term “lender” to refer not just to your lender but also investors and servicers.
Why Escrow Taxes and Insurance Fees?
Most people find that it is easiest on their pocketbooks to pay their taxes and insurance on a monthly basis, so they welcome escrow accounts. Face it: it takes an extremely disciplined person to remember to set aside money every month on their own so that there’s enough to pay those bills when they are due every year. And it is too easy to dip into those funds to pay other bills if the money is sitting in your desk drawer or even in the bank. So look at an escrow account as a form of forced savings, assurance that the bills will be paid on time without penalty or late fees.
An escrow account is set up to collect your payments for property taxes, homeowners insurance and possibly other items, in equal amounts over a 12-month period, to be paid on your behalf when those bills come due.When lenders require escrow accounts, the law limits the amount borrowers must pay. Generally, the lender will divide the cost of your anticipated property tax by 12 and collect that much each month in addition to your payment for principal and interest. It will do the same to cover the cost of your homeowners insurance, plus any other items for which escrow might be required, such as your homeowners association dues or flood insurance. And taken all together, these costs will equal your payment to escrow.
How is the Amount of Money Placed in Escrow Determined?
To get an idea what your monthly escrow payment will be, simply add up all these charges and divide by 12. For example, if your annual tax bill is $2,000 and your insurance is $600 a year, than your escrow payment will be $216.67, or $2,600 divided by 12.
Also realize that the law allows lenders to maintain a “cushion” of no more than one-sixth of the total amount paid out of the account — two months’ worth of payments — so that the escrow account always has a balance. And realize that your escrow payment could change every year if your taxes or insurance costs go up, or if the cushion amount needs adjusting.
Despite this rather long explanation, all this should happen automatically. But that doesn’t mean that mistakes aren’t made, so you should check your account periodically. You’ll know something is amiss if you get a late notice from the county or your insurer. But don’t worry: the lender should pay all penalties for failing to pay on time.
Toward that end, the law requires that you be given a complete breakdown within 45 days after establishing the escrow account, showing the anticipated amounts to be paid over the coming year. You also must be provided with a free annual statement that details activity in the account — what bills were paid and when — as well as an explanation of how much you must pay in each of the next 12 months to keep your account current.
When the loan is brand new, lenders tend to lowball the amount they collect for taxes and insurance primarily because they can only estimate those costs. Plus, it makes your initial payments more affordable. So, plan for an increase in the escrow portion of your payment — the TI (tenant improvement) part of your PITI (principal, interest, taxes and insurance) — after the first 12 months. Sometimes the hike will be large enough to give you a jolt, so be ready.
What If You Have an Escrow Shortfall or Surplus?
If there’s a shortfall in your escrow in any given year, your lender is likely to offer some options to make up the difference. For example, you can pay the shortfall in full now or via 12 equal payments over the following year, so the deficit is made up by the next anniversary of your loan. Sometimes, you may even be offered a combination of the above — pay some now and the rest over the next 12 months.
If there’s a surplus in your account — the lender collected too much over the previous year — one of two things will happen, depending on the size of the overage. Above a certain amount, the lender will cut you a check. For smaller surpluses, the lender will apply it to next year’s escrow payments. If you’re given a choice, realize that what lenders giveth in one year is likely to be taken away next year in the form of a tax increase or higher insurance premiums. Unless you absolutely, positively need the money, it’s almost always better to let it ride.
Lew Sichelman is a nationally syndicated housing and real estate columnist. He has covered the real estate beat for more than 50 years.