Insurance Escrow 101
An escrow account is established to collect payments such as your homeowner’s insurance, property taxes and other items in equal installments over the year. The bills are then paid as they fall due. If the lender agrees you can pay the bills yourself.
The mode of payment is at the sole discretion of the lender or the investor who finally purchases your loan. Because it is in the interests of the investor that you pay all the bills as required, they always prefer an escrow arrangement. For example, you fail to pay your property taxes, at the end of the day this will lead to a tax lien against the property (which ranks higher than theirs). If you are behind in your insurance payments and a major fire destroys the house, there will be no protection to cater for rebuilding costs, yet the house is the basic collateral for your home loan.
If you are a first-time homebuyer, a little explanation is in order. Lenders are the primary funders of mortgages, they normally sell their loans soon after closing to other investors trading on the secondary markets. Examples of such investors include banks, pension funds or investment entities. The final buyer of your loan typically engages a third-party servicing firm to collect your payments and distribute the funds. So, the term lender may refer to your lender or servicers or investors.
Dealing with escrow taxes and insurance fees
Most people prefer escrow accounts because they find it easier to pay their insurance and taxes monthly. It is harder to set aside funds for these obligations each month on your own, so you can pay when they become due every year. You may also be tempted to use the funds to settle these bills if the money was lying in a bank or even your desk drawer. An escrow is like a type of forced savings that ensures that the bills will be paid promptly, and you will not incur late fees and penalties
The law restricts the amount of money a borrower should pay where the lender asks for an escrow account. Usually the lender will divide the total cost of your expected property tax by twelve and this is the money they will collect in addition to the interest and principal payment. This also how your homeowner’s insurance and any other items requiring an escrow like flood insurance and homeowner’s association dues will be treated. These combined costs will be your escrow payment.
Establishing the amount of money to be placed on escrow
To get a rough estimate of your monthly escrow payment, just add these charges together and divide them by twelve. For instance, if you have an annual tax bill of $2,000 and the insurance cost is $600 per year, then your monthly escrow payment shall be $2,600 divided by twelve which comes to $216.67. Note that lenders are legally required to keep a cushion of up to one sixth of the total money paid from the account or money equivalent to two months payment to ensure the escrow account always has a balance. In addition, bear in mind that your escrow payment can change annually when your insurance or taxes increase, or if it becomes necessary to adjust the cushion amount.
While this is done automatically, mistakes do happen, and you need to monitor your account from time to time. If you receive a late notice from your insurance or county, then you will know there is something wrong. But you need not worry because the lender is required to pay all penalties for being late in payments. For this reason, the law stipulates that you be given a full breakdown within 45 days of setting up an escrow account, showing the projected amounts to be paid during the following year. You should also be given a free annual statement that highlights the activities in the account, for example which bills were paid, and an explanation regarding the amount of money you must pay in the next one year to ensure your account stays current.
If the loan is new, lenders have a tendency of underestimating the money they collect for insurance and taxes mainly because they are only able to estimate these costs. In addition, it means your initial payments become more affordable. Therefore, prepare for a rise in the escrow part of your payment-the tenant improvement (PI) portion of your principal, interest, taxes and insurance (PITI)-after the first year. Sometimes the increase may be big enough to shock you, so you need to get ready.
Escrow deficits and surpluses
In the event there is a deficit in your escrow account in a year, your lender might give you several options to settle the difference. For instance, you may pay for the full shortfall immediately or using twelve equal payments during the next year so that the deficit is cleared by the time the next anniversary of the loan comes around. At other times, the lender can give you a combination of the two methods which means you pay some money now and spread the remainder over the next one year.
If your escrow account has a surplus where the lender collects too much during the preceding year, the lender might do one of two things, based on the size of the surplus. If it is an over a specific amount, the lender will write you a check. If the surplus is smaller, it will be applied to the escrow payments for the following year. If you are told to choose, know that what the lender gives in one year will probably be taken away the following year in form of increased insurance premiums or higher taxes. It is always advisable to let it slide unless you direly need the money.
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