As your closing approaches, it seems more and more like everybody and their uncle is crawling out of the woodwork to demand your hard-earned money. You need deposits for the utilities, a great big moving truck and even more cash for something your banker swears he told you about — your mortgage escrow account.
This innocuous little account slowly melts into the background the longer you have it, so long as it functions properly. Still, a lot of people have questions about their escrow accounts that their bankers, closers and Realtors simply cannot or will not answer. Luckily for them, we’ve got it all covered in this article.
What is an Escrow Account?
An escrow account is an account where funds are stored for a future purpose, the conditions of which are spelled out in detail in a contract all involved parties must agree to. They can be used for a number of things in real estate, from construction and remodeling projects and holding down payments in a secure location to the most common usage, establishing a fund via monthly contributions from a homeowner to pay for their home’s taxes and liability insurance. Here’s a quick explanation of the different types:
Construction escrows aren’t something most homeowners will ever encounter — they’re used strictly by construction professionals in conjunction with their construction loans. Both homes under construction and those being extensively remodeled are eligible for these types of loans, but they all work in a similar way.
The contractor agrees that they will complete their project in a number of steps and provide an estimate for the amount of funding they’ll need for each part of the process. The bank then releases these funds as each step is completed to a third party company (often a title company) who holds them in escrow. The contractor can request these funds using construction draws, but he has to support his money requests with receipts.
Real estate sales escrow accounts are often just referred to as “escrows” by Realtors and the people in their offices. This type of escrow account is where your earnest money (and sometimes your downpayment) will be held until you close on your new home.
Real estate companies discovered long ago that by holding the funds, they can be confident you’ll follow-through with your agreements and not be tempted to use that downpayment money to pay for unexpected expenses prior to closing, hence the insistence on their use. This money can be refunded if there is something seriously wrong with your home or the seller doesn’t hold up their end of the deal, the terms of your escrow are spelled out in your real estate contract.
Mortgage escrow accounts, the kind we’re discussing today, are another beast entirely. They’re actually designed to make your life easier (whether they do or not is debatable) by giving you a way to pay your homeowner’s association fees, property taxes, mortgage insurance and homeowner’s insurance monthly, instead of all at once. There are very strict rules on how much money must be in the account at all time, both minimum and maximums, to protect borrowers and lenders alike.
Pros and Cons of Mortgage Escrow Accounts
Seasoned homeowners have a variety of opinions about mortgage escrows. Some spring from misconceptions, others from unusual experiences — but it’s clear that any one person you ask is going to be passionate about their escrow or lack thereof. Let me explain the pros and cons of escrow accounts for you, from the perspective of someone who has seen more than a few in action.
There are a lot of loan programs that will require you have a mortgage escrow account — you have no choice in the matter during the life of that loan. But it’s not all bad, with a mortgage escrow account, you’ll be socking money away each month for your taxes, homeowners association fees and various insurance policies you’ll need. Instead of being surprised when the first massive tax bill arrives, your mortgage company will handle it for you with the money that’s in your account. If you don’t have quite enough built up yet, they’ll loan it to you with no interest.
Some folks want to be more hands-on and prefer not to have to deal with a mortgage escrow account, though. If you’ve got a conventional loan, you may have the option to nix the escrow in favor of paying your own home expenses. You won’t save any money or get any special benefit from avoiding a mortgage escrow, but if you’ve heard horror stories about banks that didn’t pay taxes on time or let insurance policies lapse, you may find a lot of peace of mind handling your big yearly expenses on your own. Just be sure you have a plan for making your big payments, because you can’t just ignore them — many mortgage companies will call in your note if you neglect these duties.
Money Always Matters
Even though your banker and closing agent will figure out just how much money you need to bring to closing for your escrow, it’s nice to be able to estimate that figure ahead of time for yourself. There are lots of things to know about your escrow account beyond how to calculate it, though. The Real Estate Settlement Procedures Act (RESPA) outlines exactly how your mortgage escrow must be handled, funded and maintained if a lender requires one. Among the many items specified in RESPA, these are the most important in regards to your mortgage escrow account:
- Lenders are can require borrowers to maintain a cushion equal to approximately two months of escrow payments.
- Lenders are not necessarily required to pay interest on escrow accounts, this varies from state to state.
- Lenders must pay bills related to escrow accounts in a timely manner, provided that mortgage holders make their mortgage payments on time.
- Lenders can impose hazard insurance if you cancel your current policy and do not inform your bank of your new carrier.
- Lenders must reassess the amount of money required for your escrow account each year and return any excess above $50.
If you’d like to estimate your own mortgage escrow deposit for closing, you’ll need some basic information. Gather up your hazard insurance estimate, the estimated taxes for your property, and find out from your lender how much any mortgage insurance premiums will be. If you have any other types of property insurance or taxes, include those as well.
You’ll want to build a neat little chart to help you better see what you’re doing — something simple to show your monthly escrow contributions and the yearly payments that will be going out of the account. Make a column for each item that will be part of your monthly escrow contribution to keep things simple.
First, take all your payments and divide them by 12. Insert them into your chart, like so, starting with the first full month where a payment is due (this is typically the first month following closing, but may be the second if your closing is very close to the end of the month). In our example, we’ll have our closing on May 17, so your payment will be due June 1. Your hazard insurance, due in May, totals $1200 each year and your taxes, due in December, are $2400 in this example. We’re going to keep it simple and use just these two items in the chart below.
|Escrow Running Total
This is just a slice of activity from your account, so don’t get excited that we’re ignoring your initial deposit at closing — this is exactly how the pros do this calculation, too. Most banks will require that your mortgage escrow deposit at closing is equal to two months of payments (in our example, $300 per month, for a total of $600) plus the largest shortfall, negative $300 in this scenario. That means you’ll be bringing $900 to closing if you only have to escrow for hazard insurance and taxes.
If you’re among those people who are convinced that escrows are not for you, it doesn’t get you off the hook for dropping some extra cash at closing. Unless you’ve got at least a 20 percent down payment, you’ll have to pay a fee for the pleasure of having no escrow. This fee typically runs anywhere from 0.25 to 0.375 percent of the amount you’re borrowing. To put it simply, if you’re borrowing $150,000, you’ll have to pay an extra $375 to $562 to avoid your escrow. Borrowers in Illinois, New York, Oregon and Washington, D.C., are legally protected from this fee, but may also have a harder time getting their escrows waived because of the laws governing them.
Knowing that there are fees for both having an escrow and not having an escrow, it may seem like it doesn’t matter much which option you choose. After all, you’re still going to spend a bunch of money for a service you may not really need. Despite the seemingly high cost of escrow waiver fees, it’s important to note that fixed interest mortgages without escrows will always have the same payment into perpetuity. Unlike escrows with mortgages whose payments increase every year due to increases in taxes, insurance and other escrowed fees, your escrow-free mortgage payment starts and ends at exactly the same price point. Period.
When Good Escrows Go Bad
For most borrowers, the biggest concern with escrows isn’t the cost or the ability to change insurance companies without some small hassle, it’s the fear that their servicer isn’t going to actually service their escrows properly. We’ve all heard the horror stories: someone’s uncle’s neighbor’s friend came home to discover his house had been sold at a tax auction even though his escrow was supposed to be paying them, then there’s that family that only learned they had no hazard insurance when their home burned down.
Do these situations happen? Yes, of course, but it’s extremely rare. In fact, I only know of one case first hand and that was actually due to the county responsible failing to submit bills for a second parcel of land that was tied to the primary home’s tax assessment. It was a mess, but the homeowner got it all straightened out eventually. When the problem isn’t the county, but your servicer, you’ve actually got some options:
- You can (and should) send a copy of your unpaid tax bill to your lender, followed by a call. If you’ve been making your payments on time every month, they’re going to be liable for any late fees associated with their failure to pay your taxes on time, but sometimes you have to make sure they actually follow through.
- You can contact an attorney and pursue a private lawsuit under Section 6 of RESPA. Your attorney will advise you on how to proceed and whether or not the damages you’ve suffered justify legal action.
- You can submit a formal written complaint to the lender, referred to a “qualified written request” by RESPA. If you take this step, follow it up with a complaint to the government agency that oversees your lender or the Consumer Protection Division of your state’s Attorney General’s office.
If you suspect you’ve got a servicing problem, you should start keeping better tabs on the escrow reports your bank sends periodically. Checking with your county tax collector and insurance company can tell you instantly if the records you’re getting on your escrow match with the actual servicing. Sure, everybody makes mistakes, but escrow account reports that say your servicer has paid your bills when they haven’t may be more than minor accidents.
The Bottom Line: Escrows are Great, if Your Servicer Does Their Part
To escrow or not to escrow, that’s the big question. If you ask me, escrows help a lot more people than they hurt. In fact, if you’re a first time homebuyer or are just starting a family, you’ve got enough on your hands that you don’t need to borrow extra work. The old argument that you’re losing the interest that you’d otherwise make by depositing your own insurance and tax payments is a crazy one as long as savings accounts are earning less than one percent in interest. Really? One percent interest is your reason for not escrowing?
Ultimately, the decision is yours to make for many loan programs, but escrows aren’t the big, bad monsters many people want to make them out to be. I’ve owned many pieces of real estate, some with escrows and some without, and I can assure you that the mortgages with escrow accounts made me a lot less stressed. I never had to worry if I had paid the taxes or the insurance or had a sufficient pad — the bank did all that worrying for me and I was grateful. Escrows can have hiccups, there’s no doubt, but if you open all your mail and read your monthly statements, there’s little to fear from a glitch in the system.