How Does Mortgage Escrow Work?

In a mortgage escrow, borrowers contribute to an account, as part of the total monthly payment, from which lenders ensure that the property taxes and homeowner insurance fees are paid. This allows a forced savings for these large bills. However, it’s important to track your escrow payments and what your lender does with them because improperly credited escrows can cause problems with your taxes and insurance.

Federal Housing Administration (FHA) and Veterans Administration (VA) loans require escrow accounts, as do loans where borrowers put less than 20 percent down, or 10 percent in California, explains The New York Times website. Although you may no longer need an escrow once you’ve paid down the loan to 80 percent (or 90 percent in California) of your property value, some borrowers prefer to keep their accounts to simplify budgeting. Lenders don’t charge for administering the account, but borrowers do lose the opportunity to collect interest on the money by placing it into other investments.

The monthly escrow is determined by the property taxes and hazard insurance premiums projected for the next twelve months, according to the U.S. Federal Deposit Insurance Company (FDIC). Though escrow payments are set for twelve months, property taxes and insurance premiums may increase. Therefore, lenders usually keep an additional “reserve” amount in the account, although New York does not allow reserves and other states cap these fees at a certain percent or number of months.

Escrows are recalculated every twelve months based on the last disbursement. As a result, if your escrow is for a loan for a newly built home, your monthly amount can change dramatically when property taxes shift from the lower rate for an empty lot to the higher rate for one with improvements on it, according to Bankrate.com. The U.S. Real Estate Settlement Procedures Act (RESPA) requires that lenders send you an annual statement showing current payments, projected changes and any shortages, as well as return excesses over $50.

RESPA holds your lender responsible for paying your property taxes and insurance as long as you are current with your escrow payments, although problems may arise if your lender sells your loan or you refinance. The escrow account should transfer to the new lender and the old lender should give you a statement spelling out what has been collected and paid up to the time that the loan was sold. With refinancing, the escrow balance can be applied in favor of the new lender at closing or returned to you in a check with a “short-year” statement. Many of these transactions are made by computers, not humans, leaving the possibility for one or both lenders to pay taxes and insurance or not pay at all. Make sure that your lender is current with these important bill payments and track any changes.

Abrupt increases in escrow payments usually come from insurance premium or property tax changes. If your escrow payments suddenly jump, you can check and contest your property tax assessment or see if your lender may be paying for insurance that is not necessary, such as that for flooding or earthquakes.