Finance Globe

U.S. financial and economic topics from several finance writers.
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Mortgage Escrow

What is Escrow?
Escrows are used in other circumstances, but the most widely known types of escrows are mortgage-related. The escrow account is managed by the mortgage lender. The lender collects escrow payments from the borrower, and keeps the money in an escrow account until the tax or insurance payments are due. The lender takes care of paying those bills, and the borrower usually doesn't have to do anything else. When you hear about principal, interest, taxes, and insurance (PITI) payments, it means that part of the monthly house payment will go into escrow.

History of Escrow Accounts
Escrow accounts came into being in the 1930's. Many homeowners lost their homes during this period when they were unable to come up with the large, lump sum payments required to meet their property tax obligation. Lenders wanted to prevent this from happening, so they agreed to collect a prorated monthly payment for the amount of the property tax, in addition to the homeowners' regular mortgage payments. The government mandated that lenders manage escrow accounts for all Federal Housing Authority (FHA) loans in 1934. Soon after, escrows became standard practice for all mortgages.

The Purpose of Escrow Accounts
Escrow accounts serve to protect the interests of the homeowner. The homeowner can rest assured that their property tax will be budgeted for and paid on time. Without an escrow account, the homeowner would have to save up the large payment on their own; depending on the tax value assessment of the home and the county's tax rate, property tax typically amounts to several thousand dollars annually, and much more on a luxury home. It would take solid discipline and zero hardships for many homeowners to save the required tax payment on their own.

Escrow accounts typically also cover the property's fire and hazard insurance, and flood insurance or private mortgage insurance (PMI), if applicable. These expenses won't be nearly as costly as the property tax, typically only several hundred dollars a year for a modest home. So it really wouldn't be so difficult for many homeowners to budget for. But the escrow account still serves the same purpose for these expenses, to ensure that those expenses are paid on time. Escrows allow all your homeownership-related payments to be tied up into one convenient, neatly-packaged monthly payment.

Escrows also serve to protect the interests of the mortgage lender, as well as those who invest in mortgages. Lenders reduce the risk of uninsured damage to the property when they personally see to it that there is no lapse in insurance coverage. They also ensure that tax payments are made on time; lenders lost a lot of money in the 1930's when homes were foreclosed to pay tax debts. Mortgage lenders make money when homeowners can continue to live in their homes and pay mortgage interest year after year, so it's good business to help homeowners meet their obligations by collecting escrow money.

Escrows are required on many mortgages.
Escrows are so successful that most mortgage lenders require them, especially for first-time homebuyers or those who make a down payment of less than 20%. Government-backed FHA loans and loans guaranteed by the Department of Veteran Affairs (VA) require escrows as a condition of the loan. Borrowers who take on conventional loans with at least 20% down may be able to opt out of making escrow payments and take on the responsibility of paying their own taxes and insurance.

The Real Estate Settlement Procedures Act (RESPA)
RESPA does not require lenders to manage escrows, but clearly defines the way lenders are supposed to handle escrow accounts. Each month, lenders are allowed to collect 1/12 of the total annual payments for taxes and insurance. Each year, they are also allowed to collect an additional 1/6 of the total annual payments to serve as a cushion, unless state law or the loan documents limit it to less than that.

So if your total tax and insurance bill for the year is $3600, you should be paying $300 a month into escrow. You may pay $350 a month if the mortgage lender chooses to collect the additional two months' worth of payments as a cushion, amounting to the maximum allowable limit of $4200 for the year.

In the previous example, anything over $4200 would be considered a surplus. Surplus funds that can be held in escrow is limited to $50, and the lender must refund any amount that is over the $50 limit. A surplus of less than $50 may be applied to the next escrow payment. So if the lender has $4350 held in escrow, $100 would have to be refunded to the borrower. If the lender has $4245 held in escrow, the $45 would likely be applied to the next escrow payment.

So what's the money doing while it's sitting in escrow?
Unfortunately, most escrows do not pay interest. This simple fact is the main reason some borrowers don't like the esrow account requirement. They'd prefer to save and invest the money themselves, and then pay their own bills when they are due, rather than letting thousands of dollars just sit idle every year. But a small number of states have laws requiring interest to be paid on escrows; check your state's laws to see if your state is one of them.

But since escrows are mostly required of mortgages with small down payments, the benefit of escrows are more easily visible. First-time homebuyers often cannot make a large down payment simply because they haven't been able to save that much. Saving and budgeting for major expenses is often difficult for those who are just starting out. And, they may have more debt than they do savings, complicating their budget. Forced savings into an escrow account is a proven way to ensure that the money is there when the tax and insurance bills are due.

On the other hand, borrowers who can make a large down payment on their home, and aren't always required to have money in escrow, often have had the discipline, experience, and time needed to build their savings. They may have grown their assets by paying down a mortgage and building equity for many years, prior to buying their next home. They may have a considerable sum in investments that have grown over the long term, and they're more likely to have debts under control. These types of borrowers are often able to come up with the neccesary funds when needed. Tying money up in escrow may not be in their best interest, when the money serves a better purpose earning interest in their own bank or brokerage accounts until the tax and insurance payments are due.

You may be able to eliminate the escrow with a conventional loan once you've reached 80% loan-to-value ratio; check with your mortgage lender. They may require a small fee of several hundred dollars to make the change, but a disciplined saver can easily make this up in earned interest over the life of the mortgage. This will not be possible if the lender requires escrow as a condition for the loan, or for FHA or VA loans.

Errors in Escrow
Earlier I said that lender collects and pays, and the borrower usually doesn't have to do anything else. While lenders take collecting accurate escrow payments seriously, mistakes in collecting the correct amount do happen. It's the borrower's responsibility to catch mistakes before they become a major issue and cause undue financial burden.

It's important to be aware of your actual tax and insurance bills, so that you can be sure that the lender is taking out the right amount. You should initially review your escrow payment amount when you first get your mortgage. Add up your annual property tax bill and your fire and hazard insurance premium. Add in any other payments the lender will handle through escrow, such as for private mortgage insurance (PMI). Divide by twelve to get your monthly escrow payment, allowing for the extra two months the lender may collect as a cushion.

Also review your payment amount if you ever get notice of an increase or decrease in your escrow payment. Double-check their math, and call the lender if it doesn't add up. Mortgage lenders often resell their mortgages, and many homeowners will have a change in mortgage services several times due to this. When mortgages change hands, mistakes are more likely to happen.

A surplus of escrow funds means that money is tied up uselessly when you could have been using it for better things. It means that you've been paying interest on debts that could have been paid down if you didn't have to send extra money to the mortgage lender. And it means you'll either receive a refund of the excess, or you'll have a smaller PITI payment for a little while, depending on how early in the year the mistake is caught.

A shortage of escrow funds means that your budget will be temporarily skewed. You'll often have the option of making a large, lump sum payment, or to pay a higher PITI payment until you're caught up. After that, you'll probably be looking at a monthly PITI of somewhere between your previous payment and your "catch up" payments. It's normally best to spread it out through payments to keep your money in your hands longer. However, you may be better off paying it all at once if you just happen to have the extra money when you receive the notice, and you worry that higher payments for many months may interfere with your budget.

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Thursday, 30 March 2023

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