How to Use an Escrow Account for Your Benefit

If you are about to close on a loan, whether you’re buying a home or refinancing a loan you already have, you will probably have an escrow account established at closing. This account is where your monthly payments of taxes and insurance will be deposited so that when taxes and insurance are due, your servicer will have sufficient funds to pay those bills. Do you have to have an escrow account?

When Is an Escrow Account Required?

First, let’s look at conventional loans that are sold to Fannie Mae or Freddie Mac. If you are borrowing more than 80% of your home’s value, you will be required to maintain an escrow account for property taxes, homeowner’s insurance (also called hazard insurance), and most importantly, PMI (Private Mortgage Insurance). If you choose Lender Paid Mortgage Insurance, you will still have to escrow for property taxes and homeowner’s insurance. With LPMI, the PMI is built into your rate.

Related Reading: How to Avoid PMI? Know Your Options

Are There Any Circumstances Where an Escrow Is Required at 80% Financing?

• Some lenders (such as savings banks or credit unions) require you to maintain an escrow account even if your loan-to-value is 80% or lower. They do not offer an option to waive escrows (i.e., pay your property taxes and insurance on your own).
• If you are getting a FHA loan or VA loan, you will be required to maintain an escrow account even if your loan-to-value is 80% or less.
• If you are financing or refinancing a loan on an investment property, you will be required to maintain an escrow account even if your loan-to-value is 80% or less.
• If your property is in a flood zone, you will be required to escrow for flood insurance premiums (but you may be allowed to waive escrow for tax and homeowner’s insurance) at 80% loan-to-value or less.
• If you have a “Higher Priced Mortgage Loan” as defined by the Consumer Financial Protection Bureau, you may have to have an escrow account for at least the first five years of the mortgage, regardless of your loan-to-value.

If Waiving Escrows Is an Option, Is There a Fee?

It depends. This chart specifies where a lender cannot impose a fee to waive escrows (such as New York).

Does the Lender Have to Pay Interest on the Escrow Account?

Again, this depends on the state. This chart lays out which states pay interest on escrow accounts.

Who Should Waive Escrows?

If you are borrowing 80% or less and financing or refinancing a primary home or second home, and if you are getting a conventional loan, and your lender permits escrow waivers, then you should consider whether or not to have an escrow account.

The perfect situation where an escrow waiver makes sense is if you are fiscally responsible and can set aside the funds necessary to pay taxes and insurance when they are due, and also if your income is “lumpy”. An example would be if you get paid a low base salary but receive large commission or bonus checks every few months. In this case, you would prefer to keep your mortgage payment as low as possible (restricted to just principal and interest).

Conversely, if you are salaried with no bonus or commission component, you would be better off with an escrow account because then your monthly payment would cover your taxes and insurance and you don’t need to come up with a large sum when these bills are due.

What Other Factors Should Be Considered?

Some people, even if they are salaried, are adamantly opposed to “the bank using my money” via an escrow account. They believe that their lender will mishandle the escrow funds; take too much in escrow, tying up their money; or pay nothing on the escrow account and they believe they could invest those funds elsewhere and be better off.

Will My Lender Mishandle My Escrow Account?

First, it is extremely rare for a lender to mishandle an escrow account. Lenders are required to perform an annual escrow account analysis where they determine if there are sufficient funds in the escrow account. If your taxes go up, your account may have a shortfall. Same with your homeowner’s insurance. You would have to pay more whether you escrow or not.

Could You Make More Investing Your Escrow Funds?

Second, even if your state does not require your lender to pay interest on your escrow account, how much could you really make if you invested those funds yourself? And how much money are we talking about?

Let’s say for example your home in located in New Jersey, where taxes are collected quarterly (February 1; May 1; August 1; November 1). If you closed on March 15, your first mortgage payment would be due on May 1. However, three months of taxes would also be due on that date, so at closing, your lender would pick up that May 1 tax payment (meaning they would charge you three months of taxes in addition to other closing costs).

You would also probably have to escrow or give your lender anywhere from one to two month’s worth of property taxes at closing as a “cushion” to start building up for the tax bill due on August 1. In New Jersey, there is no specific requirement or limit for the cushion, so let’s use one month.

On May 1, you would make your first mortgage payment, which would include 1/12^th of your annual tax bill along with your principal and interest. On May 1, your lender would pay the quarterly tax bill using the three months of taxes they collected at closing. On May 2, how much money is in your escrow account? Two months – the one month at closing plus the one month in your May 1 payment. On June 1, you would make another payment, and now your escrow account has three months’ worth of property taxes. On July 1, you make another payment, and now your escrow account has four months’ worth of property taxes. On August 1, you make another payment, but quarterly taxes are due, so three months’ worth of taxes goes out to the municipality to pay the quarterly tax bill. So you’re back down to two months’ worth of taxes in your account.

Therefore, if we just look at the amount in your escrow account on average, it works out to 1.50 months’ worth of taxes that are “tied up” in your escrow account. That’s not a lot of money to invest.  And with rates at all time lows, you probably couldn’t earn more than 1.50% on a savings or money market account.

In summary, the most valid reasons to waive an escrow account are your own earnings stream. If it’s steady and consistent, you’re better off letting the bank escrow. If it’s inconsistent and lumpy, you may benefit from not escrowing. But make sure to set those bonus checks aside so you’ll have the funds to pay the bills when they come due.