An escrow account (also called an impound account) is an important element of a mortgage loan. Lenders like escrow accounts because they reduce the risk of the loan. Borrowers like escrow accounts because of the convenience they offer and the fact that opting for escrows often results in a slightly better mortgage deal. So, exactly what is an escrow account in a mortgage for? Why is it necessary? Why is it beneficial to have an escrow account?
What Is An Escrow Account In a Mortgage For?
An escrow or impound account is essentially a savings account that holds cash so that the lender can automatically pay your homeowners insurance and property taxes for you. When you have an escrow account, part of your mortgage payment is diverted into the escrow account and held there until tax or insurance installments come due. When that happens, the lender makes the payments automatically so you don’t have to.
Why Lenders Like Escrow Accounts
Lenders like escrow accounts because they reduce their risk in the mortgage. By making sure that property taxes and insurance are paid on time and in full, they can protect their interest in the property. For instance, if property taxes go unpaid, the taxing jurisdiction could potentially foreclose and wipe out the mortgage on the property, resulting in a big loss for the lender. If a homeowner fails to maintain his homeowners insurance and the property burns down, then the lender no longer has collateral to secure the loan.
Having said that, rarely will a lender allow a homeowner to get away with not having homeowners insurance. If they find out there’s no insurance coverage, they’ll purchase expensive “forced” insurance coverage on your behalf and pass on the cost to you. Believe me, you’re much better off carrying your own policy!
Because the presence of an escrow account reduces risk for the lender, it’s very common for lenders to offer a slightly better mortgage deal if you opt to set up an escrow account. Depending on the lender, the discount could be in the form of lower closing costs or a slightly lower interest rate.
If you’re indifferent to setting up an escrow account for your next loan, I would recommend doing it for the sake of convenience and the fact that you’ll get a slightly better deal. If you really prefer to manage your taxes and insurance on your own, ask the lender how it will impact the rate and/or fees on the loan.
If the loan has very little equity in it, meaning you’re refinancing with a high loan-to-value or you’re purchasing with a small down payment, note that the lender may not give you a choice to waive escrows.
Expect to Predeposit Escrow Funds
If your new mortgage is to have an escrow account, expect some cash to be set aside in the loan transaction to get it set up. If you’re refinancing, you can usually just roll what’s needed to set up the escrow account into the new loan balance. Once your existing loan is paid off, your old lender will refund any escrow money on deposit with them.
If you’re purchasing a home, you’ll need to bring in your escrows at closing – in addition to your down payment and any closing costs you’re responsible for.
How Escrow Deposits Are Calculated
As I mentioned, setting up an escrow account usually requires a “predeposit” of some cash to get it “caught up” to where we are in the year so that there’s enough money accumulated once tax and insurance installments are due.
To see how this works, let’s assume property taxes are $2,400 per year and due in full by the end of November. Dividing by 12 months, this means that we’ll need to collect $200 from each mortgage payment to cover the annual property taxes.
Assuming the loan closes in July, the first payment likely won’t be due until September 1 (there’s always at least 30 days after closing before the first payment is due). Between September and November, we’ll only collect 3 months worth of taxes ($600) through regular mortgage payments, so we’re going to be short $1,800 once the end of November rolls around.
To solve this problem, we’ll need to collect 11 months worth of tax installments ($2,200) at closing to get the escrow account “caught up” to where we are in the year: 9 months for the shortage and 2 months as a pad against property tax increases.
So, what is an escrow account in a mortgage for? Primarily, the purpose of an escrow account is to help protect the lender’s interest in the property by making sure taxes and insurance are paid up. However, it’s also beneficial to you because it usually results in a slightly better mortgage deal and you won’t need to write checks for taxes and insurance throughout the year.