When you purchase a house or a property, your lender might require you to have an escrow account. Whether or not you need an escrow account depends on your loan. In this article, we’ll find out what an escrow account is and whether you need one.
What is an escrow account?
Escrow account is an account the lender setup with a third party and uses the funds in it to pay your non-mortgage, property related expenses. The funds in the account covers two biggest expenses which are property taxes and home insurance, but can also include HOA dues. At the closing of a real estate transaction you might be required to prepay a few months to a year of taxes and insurance into the account. The funds covers your annual or semi-annual taxes and insurance. Your mortgage payment amount also include prorated amounts for taxes and insurance which gets transferred to the account.
Do you need an escrow account?
In the old days, escrow account is not a hard requirement; however, nowadays, more and more lenders require it. With conventional loan, you will need it if you put less than 20% down on the property. Federally backed mortgage programs (such as VA, FHA or USDA) requires it regardless of your down payment. To avoid escrow account, use conventional loan and put 20% or more down on the property you want to purchase.
What is the purpose of an escrow account?
The purpose of an escrow account is a debatable topic. Some people see it as a way for lenders to protect their own interests. Lenders avoid losing the property to unpaid tax lien, insurance or even HOA dues. Others might have a different view and see it as a way to protect homeowner’s interests. Examine the points below to see why people would have conflicting views about escrow:
Sticker shock prevention: As mentioned above, you replenish the funds in the account when you pay your monthly mortgage. The funds pay for your annual taxes and insurance (and sometimes your HOA as well). Homeowners usually face two or three large expenses that can amount to thousands of dollars once a year. In high property taxes areas like Texas, the annual property tax bill could easily exceed $10,000. That can put extra financial stress on homeowners. Lenders use escrow accounts to collect a smaller, prorated amount for taxes and insurance each month. That prevents homeowners from getting hit with a few big annual bills all at once.
Convenience factor: With an escrow account, you make a single monthly payment that includes mortgage, taxes, insurance and even HOA dues rather than making multiple payments on different schedules to the lender, county tax assessor, insurance company and HOA. This helps you reduce the work you have to do as a home owner to meet all your financial obligations consistently and on time.
Loss of interests: Most escrow accounts are not interest bearing. Although some states require escrow accounts to pay small interest rate, they don’t amount to much. Consumer advocates argue that homeowners could have earned interests on the funds set aside for taxes and insurance. The bigger issue that no one is talking about is who benefits from all the monies sitting in the accounts? If there is $5K in escrow for one borrower then there would be $50K for ten borrowers, and $500K for 100 borrowers. You get the picture? What’s the bank doing with all that money, most of which they don’t need but once a year?
Fluctuations in monthly expenses: Lenders don’t like to see fluctuation in monthly expenses for their borrowers. Most people have a fixed monthly income so fluctuations in expenses will likely bring instability and chaos. Lenders don’t like instability and chaos as that could put borrowers at risk as jeopardize the loan repayments. Lenders sees it as a big risk so they mitigate that by setting up an escrow account. And that allows borrowers to the same fixed amount of expense for their mortgage obligations.
Summary
In the old days escrow account was not a hard requirement. Nowadays, most lenders will require it on loans with less than 20% down payment; or if you go with a federally backed loan. You should check with your lender to see if an escrow is required for your situation. If you don’t have one, exercise discipline in your monthly financial obligations to avoid issues later. For more information on this, please visit the IRS website.