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Understanding Your Escrow Account

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What is an escrow account?

If you own a home and pay money toward a mortgage every month, you’ve probably noticed part of your payment goes to an account called an escrow account. While the money in your escrow account doesn’t go toward the principal or interest of your loan, it serves a different purpose altogether — funding mortgage-related expenses that are charged separately from your loan amount.

Some lenders require borrowers to set aside funds in escrow because this ensures that you’ll have the cash set aside to cover expenses like real estate taxes, homeowners insurance, and private mortgage insurance (PMI).

Escrow accounts are usually set up at the time your mortgage loan is originated. From that point, they are maintained with money from your monthly mortgage payments.

When you take out a mortgage loan, you may be given the option to have an escrow account or save the money separately and pay these expenses yourself. While there are pros and cons to either scenario, an escrow account may make keeping up with — and planning for — these housing-related bills a much easier task.

How to determine escrow payments

If you set up an escrow account to work in conjunction with your monthly mortgage payments, you won’t need to do any of the math yourself. Your mortgage servicer will determine how much needs to be paid into your escrow account each month, and they will adjust your payments accordingly.

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

  • Property taxes
  • Insurance premiums
  • Minimum balance you need to keep in your account

According to Wells Fargo, a bank and mortgage lender with a reported $5.8 billion in earnings in the second quarter of 2017, your mortgage company will start by estimating the amount you’ll owe for property taxes, homeowners insurance, PMI and any other type of insurance paid through escrow over the next 12 months. These numbers can be taken directly from tax records or from loan-closing documents related to your mortgage.

From there, your loan servicer will divide this amount by 12 months of the year, then add in your monthly principal and interest payments to come up with a comprehensive monthly mortgage payment.

You also need to carry a minimum balance in your escrow account at all times. This is due to the fact that property taxes, homeowners insurance premiums and other expenses paid through your escrow account can and do change every year. By keeping a minimum balance in your account, you can minimize any impact that arises from potential increases. Keep in mind that the minimum balance in your escrow account may be equal to up to two months of escrow payments.

How much your escrow account might change each year depends on factors no one can predict. While the principal and interest of your mortgage loan stays on a predictable path, it’s impossible to know how much property taxes or your homeowners insurance might cost from year to year. Your escrow account is used to cover these charges, but the escrow payments need to be tweaked over time to account for fluctuations in these bills.

What is a yearly escrow analysis?

At this point, you’re probably wondering how your mortgage company keeps you informed of changes to your payment and escrow requirements. Generally speaking, your mortgage servicer will provide what’s called a “yearly escrow analysis” to account for these changes and explain any change in your monthly payment. On your yearly escrow analysis, you can expect to find the following information:

  • Your current monthly mortgage payment
  • Your new monthly mortgage payment
  • Escrow account summary
  • Escrow shortage coupon or surplus check (more on this later)
  • Escrow account history
  • Expected escrow activity over the next 12 months
  • Expected escrow payments over the next 12 months

What happens if you have a surplus or shortage in your escrow account?

You’ll know whether you have a surplus or shortage in your escrow account when you get your yearly statement from your loan servicer.

If your account is falling short, your servicer will give you a “shortage coupon.” A shortage coupon is a small coupon you can cut out and send along with a payment if rising property taxes or insurance has left your escrow account in the red. Depending on your bank, you may also be able to log in and make a payment online to cover your escrow shortage. Generally speaking, you can make a full or partial payment to cover the escrow shortage or you can pay it back via a higher monthly payment over the next 12 months of mortgage payments.

If your property taxes have gone down, on the other hand, you may receive an escrow surplus check instead. Lenders are required to return any surpluses over $50. This is your money that you have overpaid, so you can cash this check and move on.

How much can my lender keep in escrow?

While the amount you are asked to keep in escrow will vary from lender to lender, certain guidelines to oversee this process have been put in place by the Real Estate Settlement Procedures Act (RESPA). This act places strict controls over how much money your lender can require for your escrow account, along with how it is paid out.

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

RESPA also dictates that, if an escrow account has a surplus of $50 or more, that amount must be returned to the borrower once the yearly escrow analysis is completed.

As a borrower, it should be fairly easy to determine if your escrow amount is being held to RESPA standards. By adding up the totals for your annual property taxes, homeowners insurance, PMI 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. Because you put less than 20 percent down when you bought your home, you also pay approximately $100 per month in PMI. In total, you may be asked to pay $4,800 in escrow expenses annually, plus keep a buffer in your account of two months of expenses.

Let’s imagine your initial property taxes and homeowners insurance premiums were paid in full for the year during your home’s closing. The first year of your mortgage, you may be asked to pay $4,800 plus two months of expenses as a buffer, or $5,600.

As a result, your monthly escrow payment would be around $466, although the total payment depends on how much your mortgage company asks you to keep as a buffer and whether that amount was funded in your mortgage closing ahead of time.

Can I opt out of an escrow account?

In some cases, your lender might allow you to skip the escrow account and pay property taxes, homeowners insurance and other escrowed bills yourself. This is particularly true if you have at least 20 percent equity in your home and if you have a solid history of repayment. At the end of the day, whether you can avoid keeping and paying into an escrow account is up to your lender’s discretion.

One big exception is the fact that FHA loans are required to have an escrow account due to RESPA. So if your mortgage is actually an FHA loan, there’s no sense in arguing over the matter.

Another situation where you won’t have an escrow account is if (and when) your mortgage is finally paid off. Once you own your home outright, you’ll be required to pay property taxes, homeowners insurance and any other housing-related bills on your own, and without prompting from a third party.

It’s important to note that you may face big penalties if you don’t keep up with these responsibilities. As the Consumer Financial Protection Bureau (CFPB) notes, failing to stay current on your property taxes could result in fines and penalties. Your state or local government could even place a tax lien on your home, and your property could fall into foreclosure.

Not paying your homeowners insurance premiums, on the other hand, will leave you uninsured and susceptible to financial injury if your property is damaged or someone gets hurt on your property and sues you.

If you opt out of an escrow account and don’t keep up with your bills, your lender might also set up a new escrow account against your will, notes the CFPB. They then have the right to add the costs of unpaid bills to your loan balance and even purchase new homeowners insurance for your property. This insurance, called “forced-place insurance,” is typically a lot more expensive than property insurance you buy on your own, notes the CFPB.

Because of the risk you take by not having an escrow account, the CFPB suggests requesting one voluntarily — even if your lender doesn’t require it.

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

 

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