Buying a house can be overwhelming, especially for first time home buyers. Rather than making the home buying process easy for buyers to understand, the real estate and mortgage industry heap piles of paperwork with confusing terminology on consumers. The concept of escrow accounts is pretty simple but it's never explained. And why in the world does it sit alongside another home buying process called the escrow process?
This article explains the “escrow” terminology used when buying a house. It starts with a timeline that shows while “escrow” is used to represent different things, there is no overlap in their use (see illustration below).
What is Escrow?
Let's start with a definition for the word escrow. It is a bond, deed or some type of document that is kept in custody by a third party until a specified condition is met. So while confusing, this word makes sense for the two different ways it's used for home buyer/owner transactions.
- The escrow process – begins with a contract to purchase a house … once it is agreed to and signed by both buyer and seller. Real estate agents are required by law to turn your deposit over to the escrow agent (title company or lawyer) to protect the money until closing where it becomes part of your down payment.
- An escrow account – is funded at closing with money (called impounds) paid towards future property taxes and homeowner insurance. Pay attention to these amounts as the loan servicer holding your money earns interest on your money … but doesn't pay you interest.
How Escrow Accounts Work
An escrow account is pretty simple. For many years I managed my own escrow account with a separate checking account which paid interest, at the time about 4%. Instead of giving that money to the mortgage servicer, I transferred the money to this checking account … to insure I had the money to pay my property taxes and insurance.
Some types of loans require a mortgage escrow account. They include FHA and USDA government loans. Conventional loans with PMI (less than 20% homeowner equity) also require an escrow account.
Here are the three types of transactions for every escrow account, whether you manage your own or delegate this responsibility to your mortgage servicer.
- Monthly deposits of approximately one-twelfth of your projected property taxes and homeowner insurance. This amount can be higher if your escrow account went negative (or below desired cushion) during the prior year. When this happens the mortgage processor loans you the money and adds a catch up amount to future payments.
- Payments are made when bills are received for property taxes and homeowners insurance. There are state regulations like Florida's escrow statutes, that require that these payments be made in time to avoid any added homeowner costs.
- Escrow analysis is done once a year by the mortgage servicer to determine what your monthly escrow payment will be for the next year. You should get a copy of this analysis with an option to:
- Pay a lump sum to give the mortgage servicer the cushion they want in your account, if there is was a shortage.
- Accept a higher monthly escrow payment (can't recall escrow ever going down) for the coming year.
Pros & Cons of an Escrow Account
Now that you have an understanding of how escrow accounts work, you have a decision to make. Do you want to hold onto your money and pay your property taxes and homeowner insurance bills when they come due? Or do you want to pay monthly and let your mortgage servicer handle payments?
Benefits of Using Escrow Accounts
- You don't have to budget or worry about having the full amount to pay property taxes or homeowner insurance when these bills come due.
- Confidence that your taxes and insurance will be paid in full, on time and you won't have added costs for late payments.
Cons of Using an Escrow Account
- You need to budget and save so you're able to able to pay your property taxes and homeowner insurance in full, when they're due.
- You're letting someone else hold your money, forgoing the opportunity to earn interest.
- You can't earn credit card bonuses for paying your homeowner insurance (not aware of this option for property taxes).
- It's more difficult to change homeowner insurance companies. While I paid for a new homeowner insurance in full, my mortgage servicer made a duplicate payment. This problem is what prompted this article!
- You can't include other homeowner expenses like home owner association (HOA) costs in escrow … unless you manage this yourself.