Managing a mortgage involves more than just making monthly payments. One crucial aspect that often catches homeowners off guard is the management of escrow accounts. Understanding how escrow works in relation to taxes and insurance is vital for maintaining financial stability and peace of mind. In this comprehensive guide, we will discuss the intricacies of escrow accounts, their role in your mortgage, and how they impact your taxes and insurance.

What is an Escrow Account

An escrow account, also known as an impound account, is a special account set up by your mortgage lender to hold funds for property-related expenses. These expenses typically include property taxes, homeowners insurance. In some very rare cases, private mortgage insurance (PMI) and homeowners association (HOA) fees are escrowed as well. Instead of paying these costs separately, your lender combines them with your monthly mortgage payment and manages the payments on your behalf. For example, you will pay the monthly portion of your property taxes in each mortgage payment and then the lender will pay the county two times per month.

The Escrow Process

1. Initial Setup: When you secure a mortgage, your lender may require you to establish an escrow account for property taxes, homeowners insurance or both. A portion of your monthly mortgage payment is then deposited into this account. If you have less than 20% down payment, your lender will require that you escrow property taxes and homeowners insurance. If you are a first time homebuyer, it is a good idea to escrow taxes and insurance as you get familiar with making a monthly mortgage payment.
   
   
2. Monthly Payments: Your lender calculates the annual cost of property taxes and homeowners insurance, divides it by 12, and adds that amount to your monthly mortgage payment. This ensures that you have sufficient funds to cover these expenses when they arise.
   
   
3. Payment Disbursement: When property taxes or insurance premiums are due, your lender uses the funds in the escrow account to make these payments on your behalf.
   • For example, if your property is in Cook County (Illinois), the lender will pay your semi-annual property taxes bills in March and August.
   • In the collar counties around Cook County, the property taxes are paid semi-annually in June and September.
   • Outside of Illinois, property taxes are paid when due annually, semi-annually or as otherwise required by the local government.
   • Homeowners insurance is typically paid annually on the anniversary of your closing date.

Advantages of Escrow Accounts

1. Predictable Budgeting: By consolidating property-related expenses into a single monthly mortgage payment, homeowners can better budget for these costs. You do not have to worry about forgetting to pay your property tax or homeowners insurance bill on time. More importantly, you cannot forget to save for the bills and then be surprised by a property tax bill that you cannot afford!
   
   
2. Avoiding Lapses in Coverage: Escrow accounts ensure that property insurance remains current, preventing lapses in coverage that could leave you financially vulnerable. If your homeowner’s insurance lapses and there is a fire or other catastrophe, you risk losing your home but still having to payoff the mortgage. Even if there is no catastrophe, having your property insurance lapse is a bad thing. If the lender finds that your insurance is not being paid, they may force place property insurance at a cost that is a multiple of your current premium cost.
   
   
3. Meeting Tax Obligations: Property taxes are a significant financial responsibility. Escrow accounts help you stay on top of these payments. If you are late on paying your property taxes, there are penalties that get more expensive the latter that you are. If you fail to pay your property taxes, the county or other local government may put a lien on your property which will prevent you from refinancing your mortgage or selling the property without paying the taxes and penalties. In the extreme, the county may sell off the tax lien to another party who can then try to seize your property.
   
   
4. LOWER INTEREST RATE & FEES: Lenders will offer you a lower rate or fees when you escrow your taxes and insurance compared to paying your own property bills. The reason is simple. The rate is lower because the risk is less if the bank pays your taxes and insurance. No matter how good your credit is, an individual person is a much greater risk to pay their taxes and insurance than a financial institution with a corporate credit rating and systems in place to pay insurance and taxes on time.

Disadvantages of Escrow Accounts

1. Inefficient Cash Management: When banks escrow insurance and taxes, they not only take enough cash to pay the expected payment, but they take an extra couple of months of tax and insurance payments. This extra cash is meant to cover increases in property taxes and homeowners insurance that are not expected. This cushion is held in the escrow account so that the lender does not have to come back to you for additional money when the bills need to be paid. If you are very conscious of your cash management, this is not very efficient compared to paying your own taxes and insurance and keeping the cushion in your own checking account.
   
   
2. Lost Interest Earnings: Escrow account hold your money but do not pay the borrower interest on the cash held. If you are very conscious of your interest earned on cash, this is lost earnings. When short term rates were near 0% this was not a big deal, but now that you can earn 4-5% on a savings account or certificate of deposit, these lost earnings may mean more to you. Your lost earnings are not the same as if the money were invested in long term assets such as mutual funds or stocks. Because you typically pay property taxes semi-annually, the money you hold on your own to pay taxes should never be in anything riskier than a savings account or six-month CD.
   
   
3. Loss of Control: It is your money and you do not want anyone else to hold it or spend it on your behalf, even you mortgage lender. Many people think this way. If you are willing to pay a higher rate and fees for this privilege and you have 20% down payment, GO FOR IT!

Managing Your Escrow Account

1. Annual Escrow Analysis: Lenders conduct an annual escrow analysis to ensure that your account has enough funds to cover upcoming expenses. If you need more money than is currently in your escrow account to pay expected expenses, you may be given an option to make an upfront payment or pay more escrows in your monthly payment over a period time. This may result in adjustments to your monthly payment. If there is a large increase in your monthly payment due to an increase in taxes, keep in mind that the real culprit is the property tax bill and not the escrows calculated by the lender. If you did not like the increase in your escrow payment, keep in mind that is much worse to pay the entire property tax bill at once!
   
   
2. Challenges and Disputes: If you disagree with your lender’s assessment or if there are discrepancies in your escrow account, it’s essential to communicate with your lender promptly. Make sure that you are equipped with the actual property tax and homeowner’s insurance bill in hand. Lenders do not like to change their escrow calculations unless there is a strong case so be ready for a battle. Good documentation and persistence are the keys to getting changes.
   
   
3. Removing Escrows: Lenders hate to remove escrows because it increases their risk, and they are typically not paid to remove them. They do not like more risk and no reward. No one does. At a minimum, you will need to show that there is at least 20% equity in your home, and you may have to show this at your own cost with a third party appraisal. Follow these steps and you may have some luck with a great deal of persistence:
   • Review Mortgage Agreement: Start by thoroughly reviewing your mortgage agreement. Some lenders may have specific requirements or restrictions regarding escrow removal.
   • Contact Your Lender: Reach out to your lender to inquire about the process of removing escrows. They can provide information on any fees, paperwork, or conditions associated with the request.
   • Demonstrate Financial Responsibility: Lenders want assurance that you can manage property taxes and insurance independently. Provide evidence of a strong credit history, stable income, and a reliable payment history.
   • Complete Necessary Paperwork: Your lender may require you to fill out specific forms to remove escrows. Be prepared to submit any requested documentation promptly.
   • Be Persistent: You will not likely be successful the first time. Keep trying and do not give up. The lender has no economic incentive to waive your escrows, but they may do it to make you go away!

Conclusion

In conclusion, understanding the ins and outs of escrow accounts is crucial for homeowners seeking financial stability and peace of mind. By comprehending the role of escrow in managing taxes and insurance, you can navigate the complexities of homeownership with confidence. Regularly reviewing your escrow account, staying informed about tax implications, and communicating effectively with your lender will contribute to a smoother and more financially secure homeownership experience.