Many mortgage providers require homeowners to have an escrow account that covers some of the annual expenses related to property ownership. An escrow account is like a savings account that’s funded by a portion of the homeowner’s monthly mortgage payment. If your lender requires you to have an escrow account, you will be asked to provide an initial escrow deposit as well as monthly payments. To make sure you’ve set aside enough for this deposit, you can use escrow analysis to estimate your initial escrow costs for a particular property.
What is Mortgage Escrow?
An escrow account, also known in some areas as an impound account, is set up by a mortgage lender to cover the cost of property taxes and homeowners insurance. These expenses are typically billed once or twice per year and the payments can be relatively large. The escrow account allows a homeowner to make monthly deposits for these payments. A portion of each month’s mortgage payment is deposited into the account so that the correct amount is available when an insurance premium or real estate tax payment is due.
What is Not Covered by Mortgage Escrow?
The expenses paid by an escrow account are limited to real estate taxes and property insurance. An escrow account does not cover homeowner association dues, utility bills or one-time local government assessments. It will typically only cover flood insurance if required by a home’s geographic location, such as in a flood plain. Personal property insurance is also not covered by a mortgage escrow account.
Why Do Lenders Require Escrow Accounts?
If you’re required to have an escrow account, then it could be because you have an FHA, VA or another type of government-backed loan. Conventional lenders like banks and mortgage companies may also require an escrow account when a homeowner finances more than 80 percent of a home’s value in order to protect their investment. When a homeowner fails to make property tax payments, a home could be foreclosed on by local authorities and sold at a tax-defaulted property auction. Mortgage lenders avoid this complication by paying the property taxes on behalf of the homeowner from the escrow account.
Home Loan Estimate Document
Mortgage lenders are required by federal law to supply potential borrowers with a Loan Estimate document within three days of their application. This three-page form contains details about monthly payments, the loan interest rate and total closing costs. It also provides the estimated cost for property taxes and insurance. The purpose of the standard Loan Estimate document is to help homeowners understand the terms of their loans before signing on the dotted line. It does not mean that the loan has been approved. That occurs after the homeowner expresses a desire to move forward with the loan and provides personal financial information.
How to Calculate a Mortgage Escrow Deposit
When you close on a home mortgage that requires an escrow account, your lender will calculate how much you’ll need to pay for each month’s escrow deposit. This requires the lender to estimate how much you’ll need to pay over the next 12 months for property taxes and homeowners insurance. An estimate of your property taxes is obtained from your local tax office, while the cost of homeowners insurance is given by your insurance company. Additional insurance costs, such as mortgage or flood insurance, may also be factored in.
Once your annual costs have been summarized, your lender will divide the total amount by 12 to determine the amount that needs to be deposited in your account with your mortgage payment each month. Your lender will repeat escrow analysis annually since your taxes and insurance premiums are likely to change over time. Even homeowners with fixed-rate mortgages can expect to see their payment amount vary year after year due to fluctuations in escrow expenses.
Escrow Account Minimum Balance
In order to avoid a shortage of funds due to increases in taxes or insurance costs, most lenders require borrowers to keep a minimum escrow balance. The required minimum balance is usually equal to two months of escrow payments and is due when the property sale is finalized. After the first year, the lender may find that an escrow account will have more than the minimum balance after taxes and insurance are paid. In this case, the escrow account is said to have an overage. Many lenders will send a refund check to the homeowner for an overage.
An escrow shortage occurs when it turns out that you don’t have enough money in your account to cover your tax and insurance payments. This can occur when an expense is higher than the amount estimated during the annual escrow review. A homeowner is expected to make an additional escrow payment to cover any shortage or may be given the option of paying off the shortage over a period of several months.
Escrow Calculation Example
Homeowners who want to figure out their possible escrow deposit for a home purchase can use information from their Loan Estimate document about taxes and insurance payments, or they can research the payments if they don’t yet have a Loan Estimate. As an example, say a homeowner’s annual property taxes will be $3,500 and insurance premiums will be $1,300. Total costs for escrow are $3,500 + $1,300, or $4,800. This number is divided by 12 to determine the monthly payment, so $4,800/12 means a monthly escrow payment of $400 will be added to the mortgage payments for loan principal and interest.
When it comes time to pay property taxes, say they turn out to be $4,100. The homeowner’s escrow account now has a $600 shortage. After this shortage is paid, the escrow payment will be increased by $600/12, which means an additional $50 per month for a total escrow payment of $450. If the lender goes ahead and pays the additional taxes before the homeowner covers the shortage, then there is an escrow deficiency. The escrow account will have a negative balance until the homeowner makes a payment.
Benefits of Mortgage Escrow Accounts
Many homeowners like the convenience of an escrow account, despite that fact that it means higher monthly mortgage payments. In most cases, property tax and insurance bills are sent directly to the lender for payment and don’t need to be tracked by the homeowner. An annual escrow statement is sent to the homeowner showing escrow deposits and bill payments. The statement will also explain what to do if there’re a shortage or overage. Because of these benefits, some homeowners ask their lender to set up an escrow account to help with the budget for home-related expenses even though the lender doesn’t require it.
Homeowners who don’t have escrow accounts with their mortgages are responsible for budgeting for taxes and insurance, which can be large expenses to pay at one time. They also must keep track of when payments are due. Failing to pay on time could result in fines and penalties, as well as having the payment amounts added to their loan balance and an escrow account added to the home loan. A lender may also sign up for new homeowners insurance on behalf of the homeowner, then send the bill to the homeowner for payment. This forced-plan insurance can be more expensive than typical homeowners insurance and should be avoided if at all possible.
- You might voluntarily set up an escrow account if you'd rather pay your taxes and insurance in small amounts every month, rather than lump sums annually. Your lender requires an initial deposit to set up the account on an existing loan.
- When establishing escrow for a refinance, reference your most recent tax bill for the tax rate. Don't refer to your most recent tax bill for an amount, however. The tax amount on your previous bill is based on your home's last assessed value, which may differ from your home's value after the refinance.
- Lenders are required to pay interest on escrow accounts in certain states. Refer to your lender for information on interest-bearing escrow accounts.
- Lenders are not required to maintain an escrow cushion. In fact, the Real Estate Settlement and Procedures Act limits the reserve cushion to two months of taxes and insurance.
Catie Watson spent three decades in the corporate world before becoming a freelance writer. She has an English degree from UC Berkeley and specializes in topics related to personal finance, careers and business.