First-Time Homebuyer’s Guide: Part 17
Understanding mortgage escrow accounts: 5 FAQs
Among the costs associated with closing a home loan is the funding of an escrow account. In general, escrow refers to a neutral third-party trust that holds funds or important documents during a transaction. In retail lending, escrow can be used for a number of purposes, such as to hold the title or earnest money (the initial financial commitment to buy a given home). This article will focus on the account established at the closing table to help ensure that the borrower regularly makes mortgage payments after the transaction is final. This is called the mortgage escrow account.
If you’re unsure how mortgage escrow works or whether it’s necessary, below are five frequently asked questions to ponder.
Why is it necessary?
Mortgage escrow is primarily concerned with two aspects of the monthly loan payment, property taxes and home insurance, abbreviated as ‘TI’. The meat of the loan is concerned with principal and interest, or ‘PI’. Together, they are abbreviated as ‘PITI’, representing the sum total of every month’s mortgage obligation. Apart from their respective dollar values, the major difference between TI and PI is that TI is variable, while PI is constant within a fixed-rate mortgage, and before the adjustment period of an adjustable rate mortgage (ARM). Property taxes and insurance premiums are subject to fluctuations, and this is the major reason that lenders establish mortgage escrow accounts: the onus of calculating and accounting for this variability is not left to the borrower, thereby decreasing the risk of payment default and lapses in insurance. Essentially, mortgage escrow serves as preemptive avoidance of bad situations.
Is it legally required to buy a home?
It depends on the loan. The Federal Housing Administration (FHA) requires mortgage escrow, not only to pay TI but also the mortgage insurance premium (MIP). Mortgage insurance is necessary for all FHA loans with a down payment that is less than 20% of the purchase price. (The retail lending version of this expense is private mortgage insurance (PMI), and is usually incurred by the same sub-20%-down-payment metric.) Retail lenders have their own specific policies related to mortgage escrow, with some requiring it and others incentivizing it by imposing an escrow waiver fee or offering lower interest rates to the borrower. Some will allow borrowers to waive the mortgage escrow altogether with little or no consequence. Such an allowance will often depend on the borrower’s down payment, debt-to-income ratio or other factors that establish financial capability and responsibility.
What’s the benefit?
TI is typically due bi-annually, whereas PI is due every month. The mortgage escrow account allows the lender to split your yearly PITI into 1/12 increments while making twice-yearly payments to the insurance company and country assessor. This helps you avoid having to manage chronologically staggered expenses and bulk payments. Essentially, mortgage escrow offers financial regularity that may be difficult to manage independently.
What’s the drawback?
While your money sits in escrow, it typically does just that: sit there, not earning interest. Some states require interest payments on escrow accounts, and they are Alaska, California, Connecticut, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New York, Oregon, Rhode Island, Utah, Vermont and Wisconsin. However, the U.S. Department of Housing and Urban Development (HUD) caps the total excess deposit amount, limiting the compounding advantages of other investment vehicles like CDs or savings accounts.
How do I know if I need one?
There are a number of factors that determine whether a mortgage escrow is right for you. They are:
- Loan type: If you have an FHA loan, you don’t have the option to waive escrow. If you have a conventional loan, you can waive escrow, but it is probably not to your advantage.
- Financial stability: If you’ve always been good with financial planning and saving, then paying TI every six months and PI every month won’t be as big of a challenge for you as it is for many borrowers.
- Consequences: Your lender will probably discourage you from waiving escrow by charging you directly or increasing the loan’s interest rate. Every customer, lender and loan is different, so you’ll need to know where you stand on this issue prior to closing by writing or calling your lender.
- Zip code: If you live in a state where escrow accounts bear interest, there’s probably little reason to waive it.
- Investment vehicles: If interest-bearing investments like CDs, money-market and savings accounts provide earnings opportunities that outweigh any negative consequences of waiving escrow, you have a good reason for managing your TI money independently.
In next week’s final edition of the First-Time Homebuyer’s Guide…