Escrow accounts are a means of paying small regular sums of money to cover large sums required at regular intervals such as annual homeowners’ insurance payments. Escrow is a good way to make sure you can make such payments when they are required.
Escrow accounts are not required by everyone, but they are useful to many home buyers. They can pay their taxes and insurances in advance by small amounts to their lenders, who in turn make the payments to the necessary authorities and companies. Although this might seem like a good idea, it is not always voluntary. In fact in many cases it is a mandatory condition of your mortgage loan that you open an escrow account.
How Do Escrow Accounts Work?
The principle is simple to understand. You will make advance monthly deposits to an escrow account to save up for your annual payments. The bank saves up your payments for you, often with interest added to your savings, and uses that to pay your home insurance and property taxes. You have no need to worry where the cash is coming from each year, because you are saving it up on a monthly basis.
Where escrow accounts are mandatory is if you are not making a 20% down payment on your new home. Your lender will apply escrow as a condition of your mortgage. Once you have paid your mortgage sufficiently for the loan-to-value ratio of your home to come down to 80%, you have the option to come off escrow.
You will also need an escrow account if you have an FHA or VA insured mortgage. Many people choose to keep their escrow account because it makes meeting annual payments much easier.
Benefits of Escrow
Escrow accounts take away all the worry of finding these annual lump sums. Even though you may be well off now, what would happen if you lost your job, or there was some form of financial crisis? You might still afford monthly payments, but perhaps not lump sum annual payments. At least your home would be secure with escrow – if you cannot pay property taxes and homeowners’ insurance, you could conceivably lose it.
Another of the major benefits of escrow is that if you have not saved enough in one year, the bank will still make the payments. The monthly amount you pay will be increased to cover the shortfall and the higher cost of the tax and insurance. You will not have to make up the shortfall in a lump sum. This is useful when these annual costs are increased during your mortgage year. Most lenders will cater for this possibility by increasing payments in advance.
Potential Issues With Refinance
Escrow accounts can present problems when you refinance or even when your lender sells your loan on to another firm. In such cases, confusion can arise regarding payment of the annual bills. There are three possibilities: the bill is correctly paid by the responsible body, it is paid by both or is paid by neither. Assuming that you have made your monthly escrow payments on time, this is not your responsibility – but the tax or insurance bodies might disagree.
You are ultimately responsible for such payments, and issues can arise before you find there is a problem. You should make sure that your annual payments are being made on time to the relevant bodies. If they are not, then inform the insurance and tax authorities of the situation. This is not likely to happen, but it is not unknown. Although nothing will ultimately happen to you, it can take time to settle the issue.