All homeowners have to pony up for property taxes and insurance. But if you buy your home with a mortgage, the chances are the lender will insist on managing these payments on your behalf. The usual process is to set up an escrow account which essentially is a piggy bank of cash you pay into every month. It's there to make sure the bills are paid on time.
Under RESPA, a lender can ask you to place 1/12 of the yearly property tax and insurance bill amounts into an escrow account each month. Lenders are permitted to keep a "cushion" equal to two months' worth of payments.
What Does a Mortgage Payment Consist of?
Assuming you haven't taken out an interest-only loan, your mortgage payment will usually cover four items:
- Principal: a portion of the loan's outstanding balance.
- Interest: the cost of borrowing money, calculated at the agreed interest rate.
- Taxes: property taxes paid to the local government. The amount is based on the assessed value of your home and the tax rate for the area.
- Insurance: homeowner's insurance, which covers you for fire, theft, hail damage, vandalism and other hazards.
This payment is often referred to by the abbreviation "PITI" – principal, interest, taxes and insurance.
What is an Escrow Account?
An escrow account is a bit like a piggy bank. Every month, your mortgage company will take the taxes and insurance portions of your mortgage payment and put them into the escrow account. When your homeowner's insurance and property taxes bills come in, your lender will crack open the escrow piggy bank and use the money to make those payments.
While there's no legal requirement for an escrow account, all mortgage lenders are entitled to ask for one as a condition of the loan. The requirement must be clearly stated in the documents you sign during the closing of your home loan.
Why Do Lenders Use Escrow Accounts?
Lenders use escrow accounts because they protect the lender. The lender needs to know that you're maintaining the insurance coverage, for example, because if you don't and the house burns down, then there's no security left to back up the loan. It's impossible for the bank to foreclose and sell a pile of ashes.
Similarly, it's important that your property tax bills are paid in full and on time. In most places, if you don't pay your property taxes, you could end up losing your home in a tax sale. This is where the taxing authority sells your home to pay off the tax debt. Property tax liens almost always have priority over mortgages, which means a tax sale would wipe out the mortgage.
Clearly, the lender will lose money big time if either of these events happens. That's why they insist on setting up an escrow account – to make sure these bills are not overlooked. For homeowners, having a bill-ready pot of cash helps you stay on top of things. You don't have to come up with a large sum of money when the property tax bill comes in, and you get to spread the cost of these payments monthly instead of having to make a lump sum payment every six months to a year.
How Much Will You Have to Pay?
The drawback to putting money in escrow is that you'll have to make a bigger mortgage payment each month. As to how much you have to pay, it's basically an estimate of what the lender thinks it will have to pay out for taxes and insurance, based on the previous property tax and homeowner's insurance bills, spread over a 12-month period.
Now, there is a risk that the lender will overestimate the amount of insurance and taxes and ask for too much money, with the result that you have a large balance in the escrow account. The reverse is also true. The bank might underestimate the payment, which means there won't be enough in the account to pay the bills, especially if there's an unexpected tax spike. You may get hit with a large bill if there isn't enough cash in the piggy bank to make the payments.
Luckily, there are federal regulations in place to protect you against the risk of poor escrow estimations.
What is RESPA?
RESPA stands for the Real Estate Settlement Procedures Act, a federal law that aims to make the real estate settlement process more transparent for home buyers. The law is overseen by the U.S. Department of Housing and Urban Development.
RESPA has two main purposes:
1. To require lenders, mortgage brokers, developers, title companies and the like to make certain disclosures about the real estate settlement process, so homebuyers know what fees they'll be in for at closing.
2. To stop unlawful and unethical practices such as referral fees and kickbacks that could drive up closing costs for home buyers.
The main thrust of RESPA is disclosure. For example, when a borrower applies for a mortgage, the lender must provide a Good Faith Estimate setting out the estimated charges the borrower is likely to pay at closing. Another required disclosure is the HUD-1 Settlement Statement. This document lists the final amount of insurances, taxes, costs and fees that will be charged to the borrower and the seller at closing – including how much you'll pay into the escrow account.
RESPA Rules on Escrow Accounts
RESPA also regulates how large of a balance your bank can maintain in the escrow account. Generally, the lender is allowed to keep a bit of a "cushion" in your escrow account to cover an unanticipated increase in taxes, but they can't ask you for too much. Here are the rules:
The lender can ask you to fund the escrow account at closing and the limit is twice your monthly escrow contribution. So, if you're due to put $300 a month into escrow, the lender can ask you to pay a maximum of $600 at closing, which is a two-month cushion or 1/6 of the annual property tax and insurance payments.
On top of the cushion, every month, your lender can require you to pay 1/12 of the disbursements payable during the year, along with the payment of principal and interest. This is the limit, meaning the lender must spread the bills evenly over the year. RESPA requires the lender to actually make the tax and insurance payments prior to their due date (as long as you are current on your mortgage payment) so you don't have to worry about organizing this yourself.
RESPA Escrow Rules in Action
Here's an example of how RESPA works. Suppose that the estimated yearly property tax for a house is $4,000 and the insurance amounts to $1,400, for a total of $5,400. Under RESPA, the lender can require a maximum monthly escrow payment of $450 ($5,400 divided by 12).
The lender can also require that an additional amount of up to $900 (two monthly payments; $450 x 2) be kept in the escrow account at all times as a cushion.
Be aware that lenders are not required to maintain an escrow cushion. RESPA only sets a limit on the maximum amount a lender can ask for to maintain a balance in the account. The trend is for lenders to require the maximum amount permitted by RESPA, but some lenders might only charge a one-month cushion or a six-week cushion if that is a more reasonable sum. The amount of cushion may then change if the lender sells the mortgage to another lender – something that happens frequently in the mortgage industry.
Year-end Escrow Account Analysis
There's another obligation under RESPA, and that's to audit the escrow account each year and tell you if there's excess money in the account or any shortage. HUD can fine mortgage lenders who don't give you an annual escrow account statement.
The statement will show your payments to and from the escrow account, the running balance and your ending history balance, which is how much is left in the escrow account at the end of the 12-month period. If there's more than $50 in the account, the lender must return it to you. Balances less than $50 are returned to you by lowering the monthly escrow payment due for next year.
Shortages, called deficiencies, are handled in one of two ways. Either the lender will collect the shortage as a lump sum to increase the funds in the escrow account. Or, the lender will divide the shortage by 12 months and add it to the monthly escrow payment. For example, an account shortage of $1,500 equates to $125 a month. The lender would add this sum to your current monthly payment of, say, $500, to give a new monthly payment of $625.
Things That RESPA Does Not Do
While RESPA offers plenty of protections for homebuyers, there are certain things it does not do. For example, RESPA does not require the lender to:
- Pay interest on the money held in the escrow account.
- Negotiate any discounts on your property taxes and insurance bills. Sometimes, an insurance company or taxing authority will offer discounts when bills are paid annually instead of in separate monthly payments. Under RESPA, the lender has no obligation to save you money.
What if the Lender is Requiring Too Much?
As a borrower, you have the right to request confirmation of the escrow amounts the lender is asking you for. Under Section 6 of RESPA, the lender has 20 business days to acknowledge receipt of your request for information, and 60 business days to provide a full response. Once the matter is investigated, you should expect any overpayment to be returned to you and your monthly payments adjusted so you're not paying more than 1/12 of the annual disbursement. Remember, the lender can keep a two-month cushion in the account.
If the lender doesn't resolve the situation to your satisfaction, you can file a consumer complaint with HUD. Be sure to provide all documentation that substantiates the disbursements to be paid from the account, such as property tax bills and letters from the insurance provider, as well as your (correct) calculation of what the escrow payments should be.
Escrow Laws By State
Many states have special escrow laws that give additional protections for homeowners. For example, some states have lower limits on the amount of cushion that a lender can hold in an escrow account; others insist that interest is paid on the account.
California, for example, requires lenders to apply a 2 percent interest rate to the escrow account balance (remember, RESPA makes no provision for interest). The District of Columbia blocks lenders from requiring an escrow account altogether where the homeowner has more than 20 percent equity in the home. In Montana, lenders can't keep more than 110 percent of the annual tax and insurance expenses in the escrow account unless the lender and borrower agree otherwise and write this into the mortgage documents. North Dakota permits a flat-rate cushion of $300.
Since provisions vary widely, be sure to check the state escrow cushion requirements where you live and seek clarification from the lender before you accept the mortgage offer.
- Truth About Mortgage: PITI: What Does a Mortgage Payment Consist Of?
- Consumer Financial Protection Bureau: Is There a Limit on How Much my Mortgage Lender Can Make Me Pay Each Month for Insurance and Taxes (The Escrow)?
- Consumer Financial Protection Bureau: Escrow Accounts
- Drendel and Jansons Law Group: The Truth About Escrow Cushions
- Comm Partners: State Regulation of Mortgage Escrow Accounts