Homebuyers typically pay extra money into escrow accounts every month, along with their home loan payments. It’s kind of like having your mom or dad hold on to your money when you were a kid while you went and played. Escrow accounts can take the pain of losing your money or not being prepared to pay a large annual bill.
How do Escrow Accounts work?
When you put money in escrow it is held by a neutral third party (called an escrow agent) who works for both the lender and the borrower. The agent’s role is to carry out the instructions agreed upon by both parties. The money is released when all the terms of the agreement are met. Escrow can be involved in anything from multimillion-dollar building projects to purchases made on online auction sites.
Audio File: Escrow or Not To Escrow
When it’s used
When your mortgage closes, your lender will usually require you to open an escrow account to cover property taxes and homeowner’s insurance. You’ll make an initial deposit, followed by payments to the account every month. (Typically these are added to your regular mortgage payment.) The escrow agent will then release these funds as your taxes and insurance premiums come due.
How Much Escrow Can a Lender Require?
The lender is not allowed to charge an excessive amount for the escrow account during the course of the loan, and there are limits on the amount that a lender may require you to put into the account.
The lender may require that you pay into the escrow account each month no more than 1/12 of the total of all payments needed during the year, plus an amount necessary to pay for any shortage in the account. In addition, the lender may require a cushion, not to exceed an amount equal to 1/6 of the total amount needed for the year.
The lender must perform an escrow account analysis once a year and notify you of any shortage, or surplus. The lender can require that you pay the amount needed to correct a shortage. If the escrow account has a surplus of more than $50, the lender must return that amount to the borrower.
What is an Aggregate Adjustment?
A formula used by lenders to ensure that the proper amount of money is collected in a borrower’s escrow account at closing to cover upcoming costs for taxes and insurance. State law governs the maximum amount that may be retained in escrow (typically 2 prorated months of property taxes and insurance premiums based on a 12 month calculation period). The aggregate adjustment may result in a credit to the borrower so that funds in excess of the allowable amount aren’t tied up in escrow.
The idea is to protect the lender by ensuring that you pay your taxes and insurance on time. If you default on your property tax, for example, your municipality can put a lien on the house, which would make it difficult to sell. Or if your house burns down and you’ve neglected to pay the insurance, the lender would be left with no collateral.
How you benefit
Escrow can benefit borrowers by helping them spread insurance and tax expenses evenly over 12 payments. For example, assume your yearly property taxes are two payments of $1,000 each, and your insurance is $400 annually. If you paid these directly, it would mean three large payments a year; your escrow costs, however, would be a manageable $200 a month.
Your escrow account will have a built-in cushion — if you miss a payment, the lender must still be able to pay your accounts on time. However, federal law prohibits lenders from requiring more than two months’ expenses in escrow. And because your tax and insurance costs will change slightly from year to year, the lender will review and adjust your escrow payments annually.
Building a new home?
Property taxes are based on land value at first. They go up when your home’s value is taxed too. To plan, put extra money towards escrow early on.
What Happens to Your Current Escrow Account When You Refinance?
Once mortgage payoff funds are posted, money held in escrow with your current lender will be returned to you from that lender. The existing escrow account cannot be transferred unless your current lender is the same as your new lender, in which case your payoff will be reduced by your current escrow balance.
How Much Money Should You Expect to Place in Escrow When You Refinance?
You can expect to place an additional 1-2 months of taxes and insurance into a new escrow account in addition to your current escrow balance. For example: you owe $100,000, your current escrow balance is $1,500, and your current monthly escrow payment is $200. At settlement, your payoff will be $98,500. Your new lender may require you to place $1,800 into the new escrow account, $300 of which is new money, and $1,500 representing the balance in your existing escrow account.
If you are not refinancing with your current lender, you will have to fund the new escrow account at the time of settlement and then wait to receive a check back from your existing lender.
When escrow may be waived
In most states, the money you place in an escrow account earns no interest for you. For that reason, many borrowers prefer to pay their taxes and insurance directly. Lenders may agree to this if your down payment is more than 20 percent, although some will raise your interest rate slightly to compensate. Once you agree to putting funds into an escrow account, however, it is difficult to cancel it, so make sure you fully understand the arrangement before your mortgage closes.
Avoiding Problems with Your Escrow Account
If you are using a mortgage to purchase your first home it is highly likely that the lender will request that you use escrow in order to handle the annual homeowner’s insurance and taxes on the property. This is reflected by an additional payment on top of the interest and principal payment that you make on the home loan. Ideally, the lender will review this account every year to see if there are overpayments or underpayments and change the escrow accordingly.
Unfortunately, we don’t live in a perfect world and companies do make mistakes. Here are some important facts to help you understand the basics of an escrow account.
Property taxes are usually reviewed one year after a home has been purchased. At this time the property will likely get a new assessment, which can drastically increase the tax amount. For people that are buying a previously owned home this will usually not be an issue, although you should look at what the current assessment value is. If you are buying a brand new home, or if you have just built a home, then the previous tax amount was based on an empty lot. The existence of a new home will greatly improve the lot’s value and subsequently change the tax amount.
Before finalizing the loan you will be asked to provide proof of insurance from a licensed insurance agent. The location of your home may dictate a few extras that might not be prevalent in other areas.
For instance, if you are considering the purchase of a home that is close to a river or lake then you may be in a flood zone and subject to flood insurance. Homes that are located in extremely rural areas may be subject to higher premiums if there are no fire fighting stations in close proximity to the home. It is vital that you speak to your real estate agent before buying a home to see if there are any conditions about the home that would result in a higher insurance policy.
How to Handle Property Tax Increases
Going back to the early example of someone buying a new home or building a home, there is the expectation that the property tax amount will increase tremendously. If the increase is more than $1,000 then the lender will possibly add $2,000 to the escrow account in case the taxes increase again the following year. This presents you with three choices:
- Accept the new escrow amount and pay the additional $167 monthly amount
- Ask your lender if they will spread the extra amount over the next two years to make the monthly amount lower
- If you have the funds, offer to pay the increased tax amount yourself so that your escrow payment does not change.
Yearly escrow review
Every year your lender should mail you a letter that goes over the escrow account for the previous year. It should list all of the payments you made to the escrow account as well as any amounts disbursed from the account to cover your expenses. You should also contact your homeowner’s insurance agent and the local tax assessor’s office to see if there are any upcoming changes for your tax bill or your insurance bill.