Escrows are often used in conjunction with home mortgages for convenience and liability purposes. Unfortunately, many people are confused regarding the actual purpose of mortgage escrows and how they work. Being forced to bundle multiple payments together adds even greater confusion to the already complicated process of closing on a home. For a better understanding of mortgage escrows, keep reading.
How Mortgage Escrow Accounts Work
The proposed sale price of a new or pre-owned home is often misleading, because it’s not the actual amount the homebuyer will pay. Homebuyers are also required to pay for homeowner’s insurance, mortgage insurance (in some cases), and property taxes, all of which further raise the total price of the home.
Are Escrow Accounts Required?
Some homeowners may prefer to pay their homeowner’s insurance and property taxes themselves rather than using an escrow account. In some cases, they are allowed do so. In other cases, however, the homeowner must use an escrow account. All mortgage loans issued by the Federal Housing Administration (FHA), for instance, must have an escrow account, whereas all loans issued by the Veterans Administration (VA) do not require escrow accounts.
So, what about loans that don’t fall under the categories of FHA or VA? According to Realtor.com, escrows are required on all conventional loans with a down payment of less than 20%. If the homebuyer places 20% or more down, he or she may have the option of paying the insurance and property taxes directly, bypassing the escrow account altogether. This is due to the fact that the homebuyer now has equity in the home.
How Escrow Payments Are Calculated
Escrow payments are calculated using a simple formula: the homeowner’s insurance, mortgage insurance and property taxes are added together, divided by twelve, and this total is added to the homeowner’s monthly mortgage payment. If the homeowner’s insurance is $500, mortgage insurance is $400, and property taxes are $3000, for instance, the annual total would be $3,900. Split across a 12-month period, that’s $325, which is added to the homeowner’s original monthly mortgage payment. Most people would agree that paying $325 per month is easier than paying $3,900 at the end of the year.
As noted by the FTC, banks that set up escrow accounts for homebuyers are required under federal law to make escrow payments for the respective escrowed services on time. Furthermore, the bank must send the homebuyer an itemized list of the estimated escrow payments over the next 12 months.
“If your mortgage servicer administers an escrow account for you, federal law requires the servicer to make escrow payments for taxes, insurance and any other escrowed items on time. Within 45 days of establishing the account, the servicer must give you a statement that clearly itemizes the estimated taxes, insurance premiums and other anticipated amounts to be paid over the next 12 months, and the expected dates and totals of those payments,” wrote the Federal Trade Commission (FTC) on its website.
Pros of Using an Escrow Account:
- Many individuals and families find it’s easier to make small, incremental payments over the course of a year as opposed to a single annual payment.
- Allowing your bank to pay your homeowner’s insurance and property taxes takes the burden off your shoulders. When you’re busy worrying about paying the power bill, gas, water, sewage, etc., you may overlook insurance and property taxes.
- You can often cancel an escrow account once you achieve 20% home equity, assuming you’ve been making payments on time. This rule varies from state to state, as some areas also include stipulations like the loan must be at least one year old with no tax or insurance due within 30 days of the preferred date of cancellation.
- Without an escrow account, at the end of the year you’ll get hit with a hefty bill for your property taxes. Granted, this should be the same (or close to) as the 12-month escrow payment, but many people have troubling paying it all at once.
Cons of Using an Escrow Account:
- While banks are required by law to distribute the escrow payments appropriately, this doesn’t always happen. There have been numerous reports of homeowners finding property bills in their mailbox – even after they’ve set up an escrow account.
- Because homeowner’s insurance premiums and property taxes fluctuate on a regular basis, so does the escrow amount. This means your total mortgage plus escrow payment may change from year to year.
- Understanding how an escrow works is undoubtedly confusing for many homeowners. This added confusion can lead to financial troubles if the homeowner isn’t prepared for the higher monthly mortgage payment.