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What is an Escrow Account?

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An escrow account is a savings account set up by your mortgage lender to pay property taxes, homeowners insurance and other expenses related to owning a home.

Instead of having to pay those large, ongoing property costs in a lump sum once or twice a year, you pay a little bit each month into the escrow account as part of your monthly payment, then the lender pays them on your behalf when they’re due.

We’ll cover the pros and cons and ins and outs of this important topic as we tackle the question: What is an escrow account?

How does an escrow account work?

Escrow accounts are also sometimes called “impound accounts,” and usually work as follows:

  1. Your lender verifies your annual property tax bill. Property taxes vary based on where you live, and the lender will check with the tax authority in your area to verify how much you owe. Taxes may rise or fall yearly, so your lender may need to adjust your property tax escrow to account for those changes.
  2. Your lender checks your homeowners insurance policy to confirm your annual premium. If you have a mortgage, your lender will need to verify you have homeowners insurance to cover losses from a fire, burglary or other types of property damage. Each year the lender will request updated coverage info and an invoice, and notify you if the premium changes.
  3. If you’re required to pay mortgage insurance, the lender calculates the annual premium. You may have to pay mortgage insurance if you make a down payment  of less than 20% with conventional financing, or take out a loan backed by the Federal Housing Administration (FHA). Mortgage insurance helps cover financial losses your lender incurs if you default on your home loan and they have to repossess it through the foreclosure process.
  4. The lender divides the yearly amounts of your homeowners insurance, property taxes and mortgage insurance by 12. You may have heard the term principal, interest, taxes and insurance (PITI): The “TI” stands for taxes and insurance, and it’s the part of your monthly payment that’s deposited into your escrow account each month.
  5. Each amount is added to your monthly mortgage payment. You’ll see the breakout of the escrow payment in the “Estimated Escrow” section on Page 1 of your loan estimate.
  6. You’ll pay money upfront to set up the new escrow account. The lender may collect an extra cushion when your escrow account is set up to cover any extra costs related to increases in your property taxes or insurance. However, if they collect too much, you’ll receive a refund usually within 30 days of receiving your first annual escrow account statement, which we’ll cover later.
  7. Each monthly payment increases your escrow account balance. Each month, the escrow portion of your PITI payment is deposited into your escrow account.
  8. When your property tax and homeowners insurance bills are due, they are paid on your behalf from your escrow account balance. Your escrow account will usually be managed by a mortgage servicer, who’ll keep track of when bills are due and pay them on time.
  9. You’ll receive an annual escrow account statement. Federal law requires mortgage servicers to provide you with an escrow account statement once a year that itemizes the payments into and out of your escrow account. They must also notify you of any shortfalls you owe or refunds due within 30 days of preparing the statement.

Is an escrow account required?

Mortgage lenders have strict rules about the types of loans that require an impound account. Remember: You have to provide the funds to set up an escrow account, which could stretch your budget if you don’t have a lot of cash in the bank to buy a home or cover the closing costs with a refinance.

Below are the most common loan scenarios that require an escrow account:

Your loan requires mortgage insurance. If you can’t come up with 20% for a conventional loan or can only qualify for FHA financing, your lender will require an impound account to make sure the mortgage insurance is paid on time. With a conventional loan, you may be able to waive the escrows once you have 20% equity, but you may also have to pay a fee.

Your loan is considered a higher-priced mortgage loan (HPML). If you have low credit scores or a poor credit history, you may still be eligible for loan approval. However, lenders may charge a higher interest rate to cover the risk that you might not repay the loan. If you’re offered a rate above the average prime offer rate (APOR), your loan may be considered a higher-priced mortgage loan. Even if you make a large down payment, lenders will require an escrow account for at least five years.

You’re paying delinquent taxes with a cash-out refinance. If you’re at least 60 days behind on your property tax payments, lenders will allow you to finance the cost of bringing them current with a cash-out refinance. The catch: You must allow them to set up an escrow account for future property tax payments.

You’re taking out a USDA loan. If you’re buying or refinancing a home with a loan backed by the U.S. Department of Agriculture (USDA), you’ll need an escrow account if your loan amount is more than $15,000. Low- to moderate-income borrowers may choose this program to buy homes in USDA-designated rural areas with no down payment.

Your lender requires escrow accounts. Many borrowers are surprised to learn that lending guidelines don’t typically require escrow accounts. For example, guidelines for military borrowers who take out loans backed by the U.S. Department of Veterans Affairs (VA) don’t require an escrow account even with no down payment. However, lenders are still responsible for verifying that property-related expenses are paid on time, so they often set their own rules for when an escrow account is necessary.

THINGS YOU SHOULD KNOW

Lenders typically require escrow accounts to avoid two major problems: tax lien foreclosures and forced-place insurance. Even if you pay your mortgage on time, if you fall behind on property taxes, the local taxing authority could assess a lien and foreclose on your home. Lenders also reserve the right to buy “forced-place insurance” if your homeowners insurance premium isn’t paid. According to the Federal Trade Commission (FTC), this insurance is usually more expensive than regular homeowners insurance.

When can I get an escrow waiver?

There are some situations where you’re permitted to pay your property taxes and insurance on your own. Keep in mind that your lender may still keep track of the status of these expenses to protect their financial interest in your house. It’s common to get an escrow waiver in the following cases:

Your mortgage doesn’t require mortgage insurance. Conventional loan guidelines recommend escrow accounts for first-time homebuyers and borrowers with poor credit, but don’t require them. However, loans that require borrowers to pay mortgage insurance must have an escrow account.

You’re taking out a reverse mortgage.reverse mortgage is a special loan product for homeowners ages 62 or older that doesn’t require you to make any monthly payments. That also means you aren’t required to set up an escrow account. However, you will need to prove that you have the means to pay these expenses based on your income or assets. If the lender is concerned you might not be able to pay the costs, they may set aside reverse mortgage funds to make sure that they’re paid.

THINGS YOU SHOULD KNOW

Some lenders charge a fee for an escrow waiver. It may be charged as a percentage of your loan amount or an increase in your interest rate. Ask your lender about a “partial escrow waiver,” which allows you to choose whether you want just your homeowners insurance or property taxes impounded. Lenders must disclose any escrow waiver fee charged on Page 4 of your loan estimate.

Pros and cons of an escrow account

Unless you have a large stockpile of savings, an escrow account is an easy way to ensure the ongoing expenses related to your home are paid on time. However, there are drawbacks.

Pros

  Your property taxes and insurance are paid without you having to keep track of them

  You’ll receive advance notice of any increases in your premiums or taxes that you can dispute

  You avoid having to budget for large, lump-sum payments for your property taxes and insurance

Cons

  You’ll have to budget for the cost of an escrow account if you’re buying a home

  You may not earn any interest on the funds kept in the account (unless you live in a state where it’s required, which we cover in the FAQs below)

  Your regular monthly payment will be higher than if you don’t have an escrow account

FAQs about escrow accounts

What is an escrow balance?

This is the amount of money currently in your escrow account. You may hear the terms “target balance” or “trial balance” as well. These are just different methods of estimating how much the loan servicer needs to cover your property expenses when they’re due. Your monthly mortgage statement should provide you with your current balance information.

Do you have to pay property taxes forever?

Local governments collect property taxes based on how much your home is worth, and they’re due for as long as you own your home. 

What does it mean to be in escrow?

This is a legal term that relates to being under contract to buy a home. When you and a seller agree to a purchase price and terms to buy a home, you are “in escrow.”

Do you get escrow money back at closing?

This is a common question when you’re refinancing, and the answer is: You’ll receive your current escrow account balance within 20 days of closing on your current refinance, according to the Consumer Financial Protection Bureau (CFPB).

How can I lower my escrow payments?

There are few ways to lower your escrow payments:

  • Dispute your property taxes. Call your local assessor if you think your property tax bill is too high, and ask about the process to dispute your bill.
  • Shop around for homeowners insurance. Online home insurance comparison sites are a good place to start if you think your homeowners premium is too high.
  • Request a cancellation of your private mortgage insurance. If home values are rising in your area, ask your loan servicer about their process for removing private mortgage insurance (PMI). For the cost of an appraisal, you may get rid of this part of your monthly escrow payment.

Can I earn interest on my escrow account?

Yes, if you’re in one of the 15 states that require lenders to pay interest on escrow account balances: Alaska, California, Connecticut, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New York, Oregon, Rhode Island, Utah, Vermont and Wisconsin.

What happens to my escrow account if my loan is transferred?

When a lender transfers your loan servicing to a new company, legally none of the terms of the loan can change. Other than making payments to a new address and servicer, your escrow account should be managed the same.

 

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