Mortgage escrow is a form of insurance for your lender. An escrow account gives the lender security that your property taxes and home insurance will be paid. This means that your home is not under threat of seizure should you fail to pay your taxes, and that it is insured in case of it being destroyed by fire or any other agency. Your lender loses out in either of these situations.
How a Mortgage Escrow Account Works
Part of your closing fee will likely be one year homeowner’s insurance. That covers you for your first year, after which you will have another year to pay. You also have property taxes to pay. The purpose of escrow is to add a certain amount to your monthly mortgage, so that the money needed for these payments is available when they must be paid.
Many mortgage lenders will require you to set up an escrow account, the contents of which the lender can use to pay recurring bills. Non-payment of these could compromise the lender’s investment. When it comes to taxes, lenders are behind the line for payment to the state and federal government. Hence the need for them to make sure that you are saving the cash in advance.
Once the escrow account has been set up, you do not pay into it yourself. The required sum is added to your monthly mortgage payment, and will be paid to the account by your mortgage lender.
Advantages of Escrow Accounts
The main advantage of an escrow account is that you do not have to find a large lump sum each year. If you feel that you are more able to pay an extra $250 each month than pay a lump sum of $3,000 annually, then it works for you. It also works for your lender, because the inability of some borrowers to meet these annual payments could mean foreclosure.
The tax people get first call on any cash available, and lenders tend to lose out from foreclosures of this kind. They also lose out in the event of non-insured destruction of your home. Not just them, but also you: you still owe your mortgage even if your home has been burned to the ground and you have no insurance. End of credit and no more car loans, credit cards, checking accounts or mortgages.
Disadvantages of Mortgage Escrow
The main disadvantage is that your escrow account does not earn interest. You might be lucky and find one that does, but it will be a very low rate. It would be far better to pay the same into an investment account, and draw it to pay your annual tax and insurance bills yourself. Whether you are permitted to do this will depend on your credit record and financial situation.
Can you avoid escrow? Yes, if you are not a first-time buyer or can make a large down payment. However, for many people, mortgage escrow is well worthwhile. It makes sure that they do not have to come up with a large lump sum each year. It is more convenient to pay recurring annual payments monthly in advance – and if they decide to sell, they don’t have to bring any property taxes up to date.