Receiving an unexpected email or a letter from your mortgage company can trigger a scary moment or two and a rush to check that you’ve made all your payments on time. But if you’ve had a mortgage for more than a year or so, you may be accustomed to seeing an annual escrow analysis from your lender. In that case, you’re less likely to panic. However, you do need to read and understand the notice.
“Escrow accounts are managed by a mortgage servicer and hold funds needed to pay property taxes and homeowner’s insurance,” says LaQuanda Sain, Executive Vice President of Servicing for Rocket Mortgage. “These accounts ensure the taxes and insurance bills are paid by consolidating them into one easy monthly mortgage payment.”
Your lender pays your insurance company and your property taxes on your behalf from the funds that are kept in your escrow account.
“A common mistake homeowners make when thinking about escrow payments is associating escrow with interest rates when in fact, rates have nothing to do with escrow payments,” Sain says. “If your mortgage rate is fixed, the amount paid toward the principal and interest doesn’t change – the amount that could change and affect the monthly payment are the taxes and insurance.”
Your homeowner’s insurance premiums and property taxes can go up or down, but they typically increase over time. Your lender estimates how much you’ll need to pay those bills, but they can sometimes collect too much or too little.
According to Dale Baker, President of Home Lending at KeyBank, your mortgage company is required to do an annual escrow analysis using the most recently available information about the cost of your property taxes and homeowner’s insurance. “When this happens, you will receive a notification as to the amount anticipated to be paid out and the monthly amount that will be collected as part of your regular payment to build the escrow balance in anticipation of those tax and insurance bills,” Baker continues.
What does an escrow shortage mean?
Sain explains that your lender will compare your escrow payments every year for property taxes and insurance to your bills for those items. In some cases, your lender may have overestimated how much those bills will be. Depending on the amount of the overestimation, you could get a refund from your lender, or they will simply lower your escrow payments for the coming year to compensate for the extra funds in your escrow account.
Most lenders collect a small amount more than you’re estimated to need for your taxes and insurance payments to avoid a shortage. If your account is short on funds, your property tax bill and your insurance premium will be paid by your lender, who will just require you to make up the difference rather than skip a payment.
“An escrow shortage can occur when the amount included in your monthly payment that is allocated to pay for your property taxes and homeowner’s insurance doesn’t cover (or isn’t projected to cover) the actual cost of the taxes or insurance when the bill for those amounts comes due,” says Baker.
“For example, let’s say your property taxes are $2,400 a year and your annual homeowner’s insurance premium is $1,200 per year. That would mean that your monthly escrow payment should be $300, plus any amount that may be collected for your escrow cushion, to ensure that your escrow account has enough money to cover the cost of taxes and insurance when the bills come due,” Baker explains. If the amount of your monthly payment allocated to escrow is less than $300 in the above example, when it comes time to pay the bills for taxes and insurance, you will have a shortage in what was collected compared to what is actually owed.
Why do escrow shortages occur?
An escrow shortage happens when the amount of taxes or insurance required in the coming year is higher than anticipated, leaving a homeowner with more fees than predicted.
“A common reason for this is because rising home values cause the taxable value to increase and, as a result, the tax bill to go up,” states Sain. “The funds in the homeowner’s escrow account then cannot cover the difference between actual and estimated price.”
What happens when you have an escrow shortage?
Your lender will let you know if they identify an escrow shortage as part of their annual analysis.
“If you have a shortage, you will be notified of the amount and the options to address the shortage,” Baker explains.
Depending on your mortgage company, you may have a couple of options to address an escrow shortage.
“Typically, the first option is to simply pay the shortage in full,” Baker says. “However, if your property taxes or homeowner’s insurance premium have increased, your monthly payment will still be adjusted accordingly to account for future payments.”
“The second option is to pay the shortage over 12 months,” Baker says. “This will also increase your monthly payment but spread the shortage balance over a manageable timeframe.”
The right option depends on many factors and will be different for each person.
Sain comments that your choice also depends on your budget and the amount of the escrow shortage.
“An advantage to paying in full is that it’s complete and out of the way quickly and all at once,” Sain says. “That option, however, may not be as easy for every homeowner. It’s important to do what’s best for you and your budget when thinking about making escrow shortage payments.”
How to prepare for an escrow shortage
Since an escrow shortage is typically more likely to occur than having too much money in your escrow account, you may want to consider allowing extra wiggle room in your budget for future mortgage payment increases even though you have a fixed rate for your principal and interest.
“You may find out that your property taxes or homeowner’s insurance cost is increasing before your mortgage company learns of the increase,” Baker says. “If you get notified of an increase, chances are, it is not accounted for in your current mortgage escrow payments. In that situation, you can anticipate a potential escrow shortage.”
If you have any concerns or confusion over your escrow analysis, the best step is to immediately contact your lender to discuss the situation and find a solution.
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.