Should I use an escrow account?
My lender insisted that I put money into an escrow account as part of the mortgage agreement. Can he do that?
Yes – if you financed your home with a government loan (ie, USDA, FHA, or VA), then an escrow account is required. No – if you purchased your home with 20% or more down using a conventional loan, in that case, it’s your decision. Additionally, if you refinanced your home loan and have 20% or more equity in your home then it’s an option and not a requirement.
Why would the lender still try and persuade me to have an escrow account if I put 20% down using a conventional loan? It’s my money to pay my property taxes and my homeowners insurance.
While this is true, mortgage lenders want to manage and mitigate their risk. Knowing that your home is insured and that it can’t be seized for back taxes gives them more confidence in using it as collateral for the mortgage loan. Specifically, city, county, and state taxing officials can usurp the first lien holder for unpaid taxes. Consequently, also as mentioned by accidental death & dismemberment claim, many mortgage lenders don’t want to leave it up to you to pay your property taxes and hazard insurance. Thus, mortgage companies will generally establish escrow accounts that have a two to three month surplus to pay insurance and taxes on an annual basis.
So how do they establish a cushion for my homeowners insurance and property taxes in my escrow account?
At closing you will normally pay the first full year of your homeowners insurance. Subsequently, you will add three months or 1/4 of the next year’s insurance payments to your escrow account. Why? In order to compensate for the lag time between closing and when your first mortgage payment is due. For example if you closed on June 15th your first payment is generally not due until the 15th of August. Consequently, your business insurance in Gresham, OR company will bill your mortgage company for the next full year payment the following May. If you did not add the three month cushion you would only have around ten months of premiums in your escrow account when your second year payment became due.
So what about property taxes?
The seller will pay taxes from January 1st through the day you close (in the scenario above it would be through the closing date of June 15th). Thus, he’s paying about four and half months of property taxes for the time he lived in the home. As mentioned before, your first payment is not due until August 15th. Therefore, you are paying about four and a half months to fund the account, for a total of about nine months of property tax payments. However, you will have to pay the entire tax bill come December. Therefore, your lender will calculate a portion of money to be put into your escrow account to compensate. It’s not an exact science – it’s a subjective assessment. His calculations will also take into account potential tax increase or decrease adjustments. Escrow accounts are usually analyzed yearly between January and March, sometimes you get money back and sometimes you have to pay a little more.
Are there any drawbacks to using an escrow account?
Once money goes into an escrow account, it generally stops working for you as most accounts don’t earn interest. In some states, escrow accounts only earn interest if the borrower requests it and meets various legal conditions. If you can keep your payments minimal, you can put more of your money into interest-bearing investments.
As with anything the responsibility is on you to monitor your escrow account. Your lender has to provide you with an annual statement showing how the money in the escrow account has been spent. It’s always recommended that you read this and confirm that your account is the right size and that your lender has calculated the payments properly. You should also check with your lender every year to make sure the payments have actually been made; there have been cases where the lender failed and the homeowners only found out when they were notified their home would be sold for back taxes.
“Anticipate the difficult by managing the easy. – Lao Tzu“
