Do I Need an Escrow Account?
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Roughly four out of five homeowners have an escrow account as part of their mortgage.
These accounts are part of your monthly payment, but go toward things like property tax and insurance instead of principal and interest. It makes sense: Having your lender make these payments so you don’t have to worry about them allows you to focus on other aspects of homeownership. Plus, lenders prefer the security and guarantee that these things will be paid.
However, escrow accounts are not required on all mortgage loans. Despite the convenience, some borrowers don’t like the idea of having thousands of dollars sitting in a non-interest-bearing account. They don’t want to pay extra money into that account just so their mortgage company can write the check for two housing-related expenses they’ve already agreed to pay.
Here’s what you need to know about escrow accounts and whether you need one.
How an escrow account works
Escrow accounts typically begin the moment you close on the house. When you buy a home, you’ll likely see references to “recurring” closing costs and “non-recurring” closing costs. Non-recurring costs are what you typically think of as closing costs — like origination fees, discount points, and appraisal, title and recording fees. You only pay these once as part of the loan approval process.
Recurring costs are tied to the ownership of real estate. The most common recurring closing costs are property taxes and homeowners insurance. The amount of property taxes you pay depends on county and city you live in. Homeowners insurance is required to protect the lender against any losses from fires, vandalism and theft.
It’s these recurring costs that calls for an escrow account. Your lender will generally set up a non-interest bearing savings when you buy a house to pay the property taxes and insurance when they come due. Each month, part of your total mortgage payment will go into this account.
If you decide that you no longer want an escrow account, or you sell your house, the balance in the account is refunded to you.
When an escrow account is required
The only loan programs that require an escrow account are the USDA and the FHA loan programs. Conventional and VA loans don’t mandate escrow accounts, but most lenders will advise you to have one if you are making less than a 20% down payment.
But if they’re not strictly required, why do the majority of homeowners have escrow accounts?
The answer: Lenders want to protect their interest in your home. If you’re delinquent on property taxes, the government can foreclose on your house even if your mortgage payment is current. Adding risk to the lender, these unpaid property taxes can take priority over a mortgage loan if you default. The state you live in may even have the right to take ownership of the home without the loan being paid off.
Lenders also want to track the payment of your homeowners insurance to make sure that the value of the home can be restored in the event of a hazardous event like a fire or vandalism. When you were approved for your mortgage loan, the lender appraised your home based on the condition it was in when you bought it. By paying your homeowners insurance every year when it comes due, you — and the lender — will be covered if something catastrophic happens to your home.
When an escrow account is optional
With a down payment of more than 20%, in most cases an escrow account is optional. The FHA and USDA programs are the exception, but most borrowers who can afford a 20% down payment likely wouldn’t apply for a FHA or USDA loan.
Here are some other scenarios where an escrow account is optional.
If you are buying investment property: If you want to control your net cash flow on your investment — the difference between your rent and the mortgage payment — you may not want to have an escrow account.
If you are taking out a reverse mortgage: Reverse mortgages are only for homeowners over the age of 62, and they do not require an escrow account. The program is designed to give you access to your equity without any monthly payment, so you won’t get a monthly mortgage statement. You can request something called a “set-aside” from your reverse mortgage lender if you are concerned about the property taxes or insurance being paid.
If you are refinancing and have 20% or more equity: If you are refinancing a conventional or VA loan and the amount of your loan is 80% or less of the value of your home, in most cases you can choose not to have an escrow account.
The advantages of not having an escrow account
Depending on how sophisticated your financial planning is, there are advantages to not having an escrow account on real estate you own.
You can invest the money you save elsewhere
Property tax rates vary based on where you live. If you live in Alabama, and are buying a house in Baldwin County, you’ll pay about $444.85 a year in property taxes for a $143,500 house (the median price for that state). If you are buying a house in the San Francisco Bay Area, where the median price is $1.6 million, your yearly property taxes will be $8,800.
It might not make sense to forego the convenience of an escrow account to invest $444.85 each year somewhere else if you are buying a house, for example, in Baldwin County, where prices and taxes are relatively low. However, on the larger tax bill for a home in say, San Francisco, you might be able to generate enough return to make it worth your while to invest.
You have a lower monthly payment
Instead of having a higher monthly bill that includes your escrow payments, you’ll just pay the entire property tax and insurance bills when they come due. You won’t have to worry about notices from the your lender and track whether the taxes have gone up or down.
You avoid increases in your monthly housing expense
If you have a fixed-rate mortgage with an escrow account, the only thing that could cause a rise in your monthly payment is that escrow account. Higher property taxes or an increase in your homeowner’s insurance premium raises the amount you pay each month. If you have a comfortable cushion of cash reserves to pay for the property taxes and insurance when they come due, there’s really no need to have an escrow account set up.
You also won’t have to wait for your yearly notice from your lender to find out your homeowner’s insurance premium went up — then negotiating for a better rate switching companies, and having to deal with your lender to make all the changes. You can just cancel your old insurance and pay for a new policy without any third party being involved.
Tips for homeownership without an escrow account
If you make the decision to cover the cost of your property taxes and insurance without the help of your lender, here are a few tips.
Be prepared to negotiate the fee for an escrow waiver: Lenders like the security of knowing your property taxes and insurance are paid with an escrow account. In fact, they consider loans without escrow accounts to be a higher risk of default. borrowers who didn’t have escrow accounts during the housing crisis were more likely to get behind on their mortgage payments than those who had them.
That’s why lenders generally charge fees to waive escrow accounts. The fee for an escrow waiver will vary by lender, but in most cases comes out to about 0.25% of your loan amount. On a $200,000 loan, that means you’ll spend an extra $500 up front if you choose not to have an escrow account.
Lenders will contact you if your property taxes are unpaid: Lenders have systems in place to track the payment of your property taxes and if you get behind, you may get a notice from them checking into make sure everything is OK. If you fall on hard times, you may be able to contact the lender to set up some type of an account to have them help budget for the payment of the taxes.
You may be forced to pay for homeowners insurance that your lender chooses: When you get a mortgage, your lender will be added to your homeowners insurance so they can be paid in the event that there is an insurable loss on your home.
If there is a lapse in payment, they have the right to force you to take insurance that they choose, usually at a much higher expense. If you change homeowners insurance companies, be sure to notify your lender so you don’t get an unpleasant letter about having an uninsured home.
Remember: Escrow expenses are always there — so shop around
When you are shopping for mortgage companies to determine who has your best rates and fees, you may overlook the expenses related to the ongoing costs of the home you are buying. The same is true when you are refinancing.
If property taxes are due in your county around the time your first mortgage payment is due, you may need to pay the entire amount due at closing. The same is true of your homeowners insurance premium: If it’s due within a month or two of when you’ll be making your first mortgage payment on a purchase or a new refinance loan, you may end up paying the entire premium due at your closing.
To escrow or not to escrow, that is the question
If you have a complex financial plan, or own a home or real estate in a place where prices and tax rates are higher, it’s worth it to have your financial planner crunch some numbers for you to determine if your money is better invested in the market than in a non-interest-bearing real estate escrow account.
If you choose not to escrow, be sure to have a system for paying your property taxes and insurance, so your mortgage lender doesn’t end up coming up with one for you. You may not need an escrow account to keep track of your housing expenses, but you absolutely need to make sure those housing expenses are paid on time to avoid any problems with your mortgage lender.