As a new homebuyer, your head may be spinning from all the real estate and lender terminology that you’re now expected to master. The concept of “escrow” sometimes causes confusion (and sometimes worry), so we’d like to lend a bit a clarity.
Simply put, an escrow account is set up to collect your payments for property taxes, homeowners insurance and possibly other items, in equal amounts over a 12-month period, to be paid on your behalf when those bills come due.
How It Works
An escrow account is set up to collect your payments for property taxes, homeowners insurance and possibly other items, in equal amounts over a 12-month period, to be paid on your behalf when those bills come due, according to the Consumer Financial Protection Bureau. You may be wondering Why you can’t I just pay these bills on my own? The answer is you can — if your lender agrees. The choice is entirely up to the lender.
But Why?
Most people find it easiest to pay their taxes and insurance on a monthly basis, so escrow accounts are a favorable choice. “Face it: it takes an extremely disciplined person to remember to set aside money every month on their own so that there’s enough to pay those bills when they are due every year. And it is too easy to dip into those funds to pay other bills if the money is sitting in your desk drawer or even in the bank”, says Newhomesource.com. Consider an escrow account as a form of forced savings; it’s a guarantee that the bills will be paid on time without penalty or late fees.
How Much Will Be Put in Escrow?
To get an idea what your monthly escrow payment will be, simply add up all the included charges and divide by 12. For example, if your annual tax bill is $3,000 and your insurance is $500 a year, than your escrow payment will be $291.67, or $3,500 divided by 12. The laws allow lenders a small “cushion”, but don’t worry. According to consumerfinance.gov, the law requires that you be given “a complete breakdown within 45 days after establishing the escrow account, showing the anticipated amounts to be paid over the coming year”.
Is the Escrow Amount Fixed?
Lenders tend to collect a lower amount for taxes and insurance on new loans, primarily because they can only estimate those costs. Plus, it will likely make your initial payments more affordable. So, plan for an increase in the escrow portion of your payment after the first 12 months. Any periodic changes in your taxes or insurance premiums will also naturally change the amount of your escrow demand.
What If There’s an Overage (or Shortage)?
If there's a shortfall in your escrow in any given year, your lender will probably offer some options to make up the difference, such as a single payment or installments broken out over the next year. “If there's a surplus in your account — the lender collected too much over the previous year — one of two things will happen,” advises newhomesource.com. “Above a certain amount, the lender will cut you a check. For smaller surpluses, the lender will apply it to next year’s escrow payments.”
Sources: Newhomesource.com; Consumerfinance.gov