When we think of our mortgage payment, we tend to think in terms of just the principal and interest. But most loans include other items in the monthly mortgage payment as well. These other payments are paid into an escrow account, established and maintained by the lender, to pay other property-related expenses such as your homeowners insurance and property taxes. Mortgage insurance, if applicable, is often included in the escrow account as well, but since it is paid out monthly it does not accumulate.
From one perspective, an escrow account provides a significant benefit to many homeowners in that it turns what are usually large lump sum payments into more manageable monthly increments. Having your taxes and homeowner’s insurance managed through the escrow account puts these two items on the next best thing to an autopilot setting.
From the mortgage company’s point of view, an escrow account protects them from two additional sources of risk. The primary source of risk is that you, as a borrower, will not pay the mortgage. You go through the application, processing, and underwriting process before you obtain the mortgage to reduce this risk.
Another significant source of risk is the potential of damage to the home. The home serves as collateral on your loan. A key piece of the mortgage approval process is the appraisal because the lender wants to ensure that the home will be marketable and that the future value is enough to significantly minimize any losses in the event you do not repay the loan. If something happens to the home it increases the potential that you will default on the mortgage, especially if the damage is enough to force you to live somewhere else, and it reduces the marketability and value of the collateral.
Property taxes are another substantial risk to the collateral because tax liens are one of the few types of liens that can take precedence over the mortgage. Taxing authorities have the ability to seize your home, sell it at auction, and collect what is owed to them before any of the proceeds are applied to the mortgage debt. And they are not likely to be concerned about selling the home for the full value as much as they are with recovering what they are owed.
I believe it is important to note that if you get a fixed-rate mortgage, the escrow account can result in your total mortgage payment increasing from time-to-time as the rates for your taxes and insurance go up. The government regulates how much money lenders are allowed to have in your escrow account over and above the upcoming expected payments. If that formula indicates an overpayment, you will be refunded the excess. But if the payments for your taxes or insurance increase, you may receive a notice asking if you wish to pay the difference in a lump sum or if you would prefer to increase your monthly payment into the escrow account.
In some circumstances, the homebuyer can elect to “waive escrows” and take responsibility for paying the taxes and insurance themselves. This is not always permitted. Most government-insured loans like FHA, VA, and USDA do not permit escrows to be waived. It is allowed on most conventional loans but there may be an additional fee associated with waiving escrows as it increases the risk associated with your loan.
If you have any additional questions about this or any other related topic, please do not hesitate to contact me at your convenience.