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Understanding Your Escrow Account

escrow account

Some homeowners with mortgages may have trouble fully understanding escrow and why it matters. With an escrow account, a portion of your monthly payment goes into a separate account to cover certain non-mortgage expenses.

To get a handle on how to put money in escrow, it’s important to remember that the funds in your escrow account don’t pay down the principal or interest on your mortgage.

What is an escrow account on a mortgage loan?

An escrow account is managed by your mortgage lender. It is typically set up when your loan is originated. From that point forward, the account is maintained with a portion of each of your monthly mortgage payments going toward property taxes, homeowners insurance and mortgage insurance (if applicable).

Your lender uses the money held in the account to pay insurance and property taxes on your behalf. This way, there’s no need to worry about coming up with a lump sum to cover those expenses by their due dates.

How to determine escrow payments

If your lender or servicer set up an escrow account at closing, you won’t need to do any of the math yourself to calculate your monthly escrow payments. Your lender or servicer will determine how much needs to be paid into your escrow account each month, and it will adjust your mortgage payments accordingly.

Determining your monthly escrow account obligation is a fairly simple task for your servicer. Once your mortgage is closed and your escrow account is set up, the deposit amount needed is determined using three factors:

  • Property taxes
  • Insurance premiums
  • Escrow account minimum balance

Your servicer will start by estimating the amount you’ll owe for property taxes, homeowners insurance, mortgage insurance and any other type of coverage, such as flood insurance, over the next 12 months. These numbers can come from tax records, your insurance company and your mortgage closing documents.

Your tax and insurance bills are then divided by 12 and added to your monthly principal and interest payments to come up with a comprehensive monthly mortgage payment. This is where the PITI acronym comes from — principal, interest, taxes and insurance.

There’s a required minimum balance that should sit in your escrow account at all times. This is because property taxes, insurance premiums and other expenses paid through your escrow account can — and do — fluctuate each year. By keeping a minimum balance — up to two months of escrow payments — in your account, you can minimize any impact that arises from potential increases.

It’s difficult to predict how much your escrow account can change each year. While the principal and interest portion of your mortgage payment stays on a predictable path, it’s hard to know how much your property taxes or homeowners insurance might cost from one year to the next. As a result, your escrow payments need to be tweaked over time to account for adjustments.

What is a yearly escrow analysis?

Escrow accounts are typically analyzed yearly to verify there’s enough money in them to cover upcoming bills for insurance and taxes. The annual escrow analysis includes information about the insurance and tax bills paid over the past 12 months with available escrow account funds. It also provides you with a rundown of how much those bills are expected to cost over the next year and how your monthly mortgage payment is expected to change — if at all.

You may expect to find the following information in your yearly escrow analysis:

  • Current monthly mortgage payment
  • New monthly mortgage payment
  • Escrow account summary
  • Escrow account history
  • Escrow shortage coupon or surplus check (more on this below)
  • Expected escrow activity over the next 12 months
  • Expected escrow payments over the next 12 months

What about an escrow account surplus or shortage?

Your annual escrow analysis will also include information on whether there’s a shortage or surplus in your escrow account.

If your account is falling short — maybe rising property taxes or insurance left your escrow account in the red — your servicer could give you a shortage coupon, which you can cut out and send with a payment equal to the shortage amount. Depending on your lender or servicer, you may also be able to pay the shortage amount online. Generally speaking, you can make a full or partial payment to cover the escrow shortage or spread it out and pay it back in addition to your mortgage payment each month over the next 12 months.

If you have an account surplus, you may receive an escrow surplus check. Lenders are required to return any surpluses $50 or more. This is your money that was overpaid, so you can cash the check.

How much can my lender keep in escrow?

The amount you’re required to keep in escrow can vary by lender. However, certain guidelines are in place by the Real Estate Settlement Procedures Act (RESPA) to oversee this process. This act places strict controls over how much money your lender can require for your escrow account, along with how it is paid out.

Through RESPA, your lender can only require you to pay up to 1/12 of the total needed per month for all annual escrow items during the year. The lender may also require a cushion that can’t exceed an amount equal to 1/6 — or two months — of escrow payments for the year.

RESPA also enforces the previously mentioned rule that if an escrow account has a surplus of $50 or more, it must be returned to the borrower within 30 days of the yearly escrow analysis being completed.

Do you have enough in your escrow account?

As a borrower, there’s a straightforward way to determine if your escrow amount is being held to RESPA standards. By adding up the totals for your annual property taxes, homeowners insurance, mortgage insurance and other housing-related bills paid through escrow, you can make a quick calculation on your own. Here’s an example:

Let’s say you owe $2,400 in property taxes annually, along with $1,200 in annual homeowners insurance premiums. Additionally, because you put less than 20% down when you bought your home and have a conventional mortgage, you also pay $100 a month in private mortgage insurance.

Escrow Item Annual Amount
Property taxes $2,400
Homeowners insurance $1,200
Private mortgage insurance $1,200
Total $4,800

In total, you may be asked to pay $4,800 in escrow expenses annually, plus keep a buffer in your account of two months’ worth of expenses. To calculate two months of escrow expenses, first divide $4,800 by 12 to get $400, which is one month of escrow expenses. Two months equals $800.

So during that year, you may be asked to pay $4,800 plus an $800 buffer, for a total of $5,600.

As a result, your monthly escrow payment would be around $467 ($5,600 divided by 12), although the total payment depends on how much your mortgage servicer asks you to keep as a buffer and whether that amount was funded at your mortgage closing ahead of time.

Can I opt out of an escrow account?

Some mortgage lenders require escrow accounts, such as those who originate loans backed by the Federal Housing Administration (FHA) and U.S. Department of Agriculture (USDA). Conventional lenders and those who originate loans backed by the Department of Veterans Affairs (VA) don’t require escrow accounts, but they advise them for borrowers making less than a 20% down payment because there’s more risk involved and they want to protect their interest in the home.

If you put down 20% or more, you may be given the option to have an escrow account or save the money separately and pay these expenses yourself. If you want your lender to consider granting you an escrow waiver, you’ll not only need a larger down payment, but you must show your ability to handle lump-sum payments of your insurance and taxes. There may also be a waiver fee involved, which might cost 0.25% of your loan amount, though it’s best to double-check with your lender. While there are pros and cons to either scenario, an escrow account can make keeping up with — and planning for — these housing-related bills much easier.

At the end of the day, whether you can avoid keeping and paying into an escrow account is up to your lender’s discretion. The lender wants assurance that your taxes and insurance bills are covered because missed payments can lead to a lapse in homeowners insurance coverage when it’s most needed or a property tax lien that would take priority over late mortgage payments if you default.

If and when your mortgage is paid in full, you won’t need an escrow account. Once you own your home outright, you’ll still be required to pay property taxes and any other housing-related bills on your own and without prompting from a third party.

Can you cancel an escrow account?

Once you’ve been diligently paying down your mortgage on time and build 20% equity, your lender may give you the option to cancel your escrow account. Requirements to drop escrow payments might also include not having a tax or insurance bill due within 30 days of the cancellation request.

Quicken Loans requires borrowers to meet the following requirements to cancel their escrow account:

  • Have equity: You need 20% for a conventional loan and 10% for a VA loan.
  • Have a good credit score: You need a 680 for a conventional loan and 720 for a VA loan.
  • Have at least a 1-year-old mortgage: Loans backed by Freddie Mac or the VA must be a year old, while Fannie Mae loans must be 2 years old.
  • Have a positive escrow account balance.
  • Be current on mortgage payments: You can’t have any 30-day late payments in the past year. Also, you can’t have any 60-day late payments in the past two years for Fannie Mae loans.

If you’re able to opt out of an escrow account but don’t keep up with your bills, your lender might set up a new escrow account against your will. It can also add the costs of unpaid bills to your loan balance and even purchase homeowners insurance for your property and bill you for it. This insurance, forced-place insurance, is typically more expensive than a homeowners policy you could buy on your own.

The bottom line

Although the costs of escrow items increase your monthly mortgage payment, having an escrow account in place reduces the burden of scraping up lump sums for your taxes and insurance when they come due each year.

Even if you can and want to opt out of an escrow account, it may be safest to have one anyway so that your annual obligations are handled without interruption.

While paying money into an escrow account may feel like you’re just throwing it away, it’s important to remember that the money is still yours. You’re required to pay your property taxes, homeowners insurance and other bills regardless, but an escrow account makes the process easier.

The information in this article is accurate as of the date of publishing. 

 

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