First-time homeowners often can be confused by the concept of the mortgage escrow account – what is it for and how does it work?
A mortgage escrow account is a separate account that is dedicated to specific bills and expenses related to mortgages. It is designed to make sure people have not dedicated so much money to the purchase of the house that they are unable to pay other large mortgage-related expenses, such as homeowner's insurance or property taxes.
Think of the escrow account as a form of auto-payment system, where a portion of your mortgage payments is diverted to the escrow service. The escrow service in turn takes care of the property tax, insurance and any other payments that are specified within the mortgage paperwork.
Responsibility for payments under an escrow account is shifted to your lender. They must make these payments and are required under RESPA (Real Estate Settlement Procedures Act) to give you annual escrow statements. You will need to check the statement to make sure the lender made payments as required and on time to avoid late fees or penalties. The lender should pay any such fees if they incur.
Since property taxes change periodically, so will your escrow payments. Adjustments are made annually and spread out equally over the year.
The lender will take care of any shortfall caused by a rapid property tax rise, but they will generally require a cushion of early payments in the escrow account to prevent this situation. The amount of that cushion will be established at closing, and you should be notified of the expected amount well in advance.
The escrow amount is limited under RESPA (Real Estate Settlement Procedures Act) to keep banks from excessive risk mitigation that costs consumers. Lender' escrow cushion cannot be more than one-sixth of the items to be paid from the accounts. According to HUD, this generally works out to around two months-worth of escrow payments.
Escrow accounts may be for a certain period of time, or may continue for the life of the loan. You can request escrow cancellation from your lender after you have reached a certain level of equity in your home, typically at least at the same 20 to 22 percent mark where private mortgage insurance can be dropped. However, lenders are not obligated to grant your request.
What if you prefer to pay your own taxes and don't want an escrow account? You may not have a choice; it is mandatory in some cases. The Truth in Lending Act (TILA) requires escrow on some higher-priced mortgages.
Contrary to popular belief, FHA does not require escrow on loans they insure – but since they are inherently higher-risk loans, lenders usually require escrow (and may blame the FHA). Lenders ultimately decide, since they assume the risk.
If you are allowed to avoid escrow, you will likely pay a higher interest rate, as you pose a greater risk to the lender by assuming responsibility for your own property taxes and insurance.
Why would you want to avoid escrow? Interest rates are minimal or nonexistent with an escrow account, depending on any state mandates. In essence, escrow costs you a certain amount of money in interest, since you can't place your money in an investment with higher return. Of course, sometimes investments lose money…
For most people, escrow accounts provide peace of mind, with fewer regular payments to remember. More independent homebuyers may find it a nuisance. Work out escrow details with your lender, and if you do not like their terms, try negotiating them or consider other lenders.