If you are taking out a mortgage to purchase a home, your lender may require you to have an escrow account for the purpose of paying taxes and other items. Read on to learn how mortgage escrow accounts work, what items your escrow money will go towards, and how having this type of account this may actually help you out.
When it comes to mortgage accounts, the term “escrow” means something different than it does when you buy a home. In a home purchase, escrow refers to when a neutral third party collects and disburses the required funds and documents involved in the closing process.
With a mortgage escrow account, on the other hand, you pay extra amounts to the lender along with your monthly payment of principal and interest. The lender puts these amounts into a special account (a mortgage escrow account) and pays certain property costs, including taxes and insurance, on your behalf out of that account.
There are a few terms and acronyms you should know about when dealing with mortgage escrow accounts. For example, a mortgage escrow account is sometimes called an “impound” or “trust” account.
Also, a mortgage escrow account pays for taxes and insurance, which are usually referred to as T&I. The mortgage payment, which consists of principal and interest, is called P&I. All together, these items are called PITI (principal, interest, taxes, and insurance).
If you have a mortgage escrow account, you must pay an estimated portion of certain annual costs to the lender each month. Escrow payments are made at the rate of 1/12 of the yearly amount due. The lender might also collect a little extra—called a "cushion"—to cover unexpected increases in costs. This money is set aside to cover various costs including property taxes, homeowners insurance, and private mortgage insurance. These items are collectively called “escrow items.” The idea is to protect the lender from the possibility that you won't regularly pay these on your own.
In most cases, the tax and insurance bills are sent directly to the mortgage lender. The lender or servicer (the company you make your monthly payments to) then pays these bills when they become due—typically once or twice a year.
If your property costs change (for example, your property is subjected to a tax reassessment or your homeowners' insurance carrier raises its rates), your escrow payment will change.
Each year, your mortgage servicer will review your escrow account to make sure the escrow portion of your monthly mortgage payment covers the taxes and insurance premiums while also maintaining the minimum escrow account balance, if there is one. This is called an escrow analysis.
To find a copy of your most recent escrow analysis and get details about your escrow account, you can:
Mortgage lenders do not require all homeowner/borrowers to have an escrow account, and you may be able to cancel the account at some point. For some, it required; for others, it is merely an option. (Certain types of loans require the mortgage lender to set up an escrow account. Learn more in Can I get rid of a mortgage escrow account and pay property taxes and insurance on my own?)
If you don’t have an escrow account, you are responsible for paying the taxes and insurance directly, usually in one or two large payments each year.
If you are responsible for paying the property taxes on your own, but you fail to pay them, the taxing authority may:
You could also potentially face a foreclosure. (Learn more about property tax foreclosures.)
Alternatively, the lender may advance the cost of the property taxes out of its own funds to protect its interest in the property and then add this amount to the total you owe. If you don’t pay up, you’ll most likely be in violation of the terms of the mortgage contract and the lender will be able to foreclose. (To learn the ins and outs of the foreclosure process, visit Nolo's Foreclosure Center.)
If you fail to purchase homeowners' insurance, your lender may buy a policy—called “force-placed” insurance or “lender-placed” insurance—and add the amounts to your loan balance. This type of insurance typically costs more and provides fewer benefits than insurance that you could buy on your own. (Learn more about force-placed insurance.)
Mortgage lenders tend to like escrow accounts because it ensures that your taxes and insurance premiums are paid on time and in full. Having an escrow account can also make your life easier because you don’t have the pay the insurance and taxes in lump sums, but instead you get spread out the payments over the year.