Mortgage Loan Escrow Account

Another confusing part of the mortgage loan closing. The escrow account funds are wrapped into the total closing cost on the loan estimate and they are a cash outlay at the time of the closing. But are these funds an actual transaction cost? Read on to find the answers.

What is a Mortgage Loan Escrow Account?

A mortgage loan escrow account is a separate financial account managed by the lender or servicer of your mortgage loan. A key distinction here is that if you sell your home (or refinance your mortgage loan) the remaining balance of the escrow account, unlike the closing transaction costs, comes back to you. So, the escrow account is your money held by the lender for the purpose of paying your property-related future expenses on time. These expenses typically include:

• Property Taxes: The escrow account collects funds monthly as part of your mortgage payment to cover annual property tax bills.
• Homeowner’s and Flood (if applicable) Insurance: Similarly, the escrow account collects funds to pay for your homeowner’s and flood insurance premium when it is due.

Understanding how the escrow account works can help you better anticipate changes in your monthly mortgage loan payment and cash flow.

How does the Mortgage Loan Escrow Account Work?

• Monthly Contributions: When you make your monthly mortgage payment, a portion goes toward the loan’s principal and interest, while another portion is deposited into your escrow account.
• Payments on Your Behalf: The lender uses the funds in the escrow account to pay your property taxes and insurance bills directly when they come due.
• Adjustments: Each year, your lender reviews the account to ensure there is enough money to cover these expenses. If property taxes or insurance premiums increase (or decrease), your monthly escrow payment may be adjusted.
• Monthly Statements: The monthly statement from your lender will show the current escrow balance and any distributions that have been made.

 

How Is the Initial Escrow Contribution Calculated?

The initial amount required to fund an escrow account is calculated based on the projected property-related expenses for the upcoming year, including property taxes, homeowner’s insurance, and any other escrowed costs. The lender needs to ensure the account has enough funds to cover these expenses while complying with federal laws under the Real Estate Settlement Procedures Act (RESPA).

Steps to Calculating the Initial Escrow Amount:

1. Annual costs: The lender will estimate total annual property costs including property taxes, homeowner’s insurance premiums, other required payments (e.g., flood insurance, if applicable). 
2. Monthly payments: The lender will divide the total expense into 12 Monthly Payments to determine your required monthly contribution to the escrow account.  
3. Due dates: The lender will review when property taxes and insurance payments are due and ensure that the escrow account has enough funds to pay these bills on time. 
4. Add a Cushion: Federal law allows the lender to collect a cushion of up to two months’ worth of escrow payments. This cushion helps cover unexpected increases in taxes or insurance. 
5. Perform an Aggregate Adjustment: To comply with RESPA’s limit on escrow balances, the lender calculates the aggregate adjustment. This is a calculation used during the creation of an escrow account to ensure that the account does not exceed the maximum balance allowed by federal law. This adjustment is made during the loan closing process when the lender initially sets up the escrow account. The aggregate adjustment is listed as a credit on your closing disclosure statement, reducing the amount you need to pay at closing.

Do I Have to Have an Escrow Account With My Mortgage?

Whether you are required to have an escrow account with your mortgage depends on several factors, including your lender’s policies, the type of loan you have, and the size of your down payment. Here’s a breakdown:

• Low Down Payment or High Loan-to-Value Ratio (LTV): If, at the time of the home purchase, you make a down payment of less than 20%, most lenders require an escrow account. This helps ensure property taxes and homeowner’s insurance are paid, protecting the lender’s investment. 
• Certain Loan Types: Government-backed loans, such as FHA, VA or USDA loans, usually require an escrow account regardless of your down payment amount. 
• Flood Insurance: For any loans made after January 1, 2016 secured by residential real estate or mobile homes and located in special flood hazard areas lenders are required to escrow flood insurance premiums. 

Pros of Having an Escrow Account

• Convenience: You do not have to manage and remember separate payments for taxes and insurance.
• Predictability: It helps budget for large, periodic expenses by spreading them out over the year.
• Protection: Ensures these critical payments are made on time, preventing lapses in insurance and/or tax penalties.

Cons of Having an Escrow Account

• Money management: You are giving up control over your money.
• Additional Income: Keeping your funds in a personal savings account until taxes and insurance are due can result in interest earnings.

Opting Out of the Escrow Account

As long as you are not getting a government-backed loan (FHA, VA, USDA, etc.), and if you make a down payment of 20% or more at the time of the home purchase, most lenders will allow you to waive the escrow account. This is known as “escrow waiver” or “escrow exclusion.” In some cases, lenders may charge a one-time fee to allow you to forgo an escrow account.

Can I Ask My Lender to Remove My Escrow Account After the Closing?

Whether they will remove the escrow account after the closing depends on several factors, including your loan type, financial profile, and specific lender policies. Here is what you need to know:

• Most lenders require that you have significant equity in your home before they will consider removing an escrow account. Typically, this means a loan-to-value (LTV) ratio of 80% or less, which occurs when you have at least 20% equity.
• A strong history of on-time payments is often required to show that you are financially responsible.
• Certain loans types, such as FHA, VA or USDA loans, often require an escrow account for the life of the loan. Conventional loans, however, may offer more flexibility.
• Some lenders may have specific rules regarding escrow accounts that prevent their removal.
• Some lenders may charge a fee for removing an escrow account, so be prepared for this possibility.
• Keep in mind that even if you meet all the requirements, the lender is not obligated to approve your request.

What Happens if There is a Shortage or an Overage in My Escrow Account?

Lenders are required to perform an annual escrow analysis to ensure your account is adequately funded. This review helps identify any potential shortages or overages and adjust your monthly payment accordingly. When there is a shortage or an overage in your escrow account, your lender will notify you and take specific actions to address the situation. Here is what happens in each case:

• Escrow Account Shortage: A shortage occurs when there is not enough money in the escrow account to cover your property taxes, homeowner’s insurance, or other escrowed expenses. A shortage may happen because your property taxes or insurance premiums increased, or because the initial or ongoing escrow contributions were underestimated. Your lender will send you an escrow analysis statement showing the shortfall and explaining why it occurred. Typically, most lenders will offer two possible options to resolve an escrow account shortage:
• Pay the Shortage in Full: You can make a one-time payment to cover the shortfall.
  Spread the Shortage Across Monthly Payments: The lender may divide the shortage over the next 12 months and add it to your monthly mortgage payment.
• Escrow Account Overage: An overage occurs when there is more money in the escrow account than needed to cover your expenses. An overage might happen because property taxes or insurance premiums decreased or, because contributions to the escrow account were overestimated. The lender will send you an escrow analysis statement showing the overage amount. If the overage exceeds $50 the lender is required to refund you the surplus amount within 30 days. 

Bottom Line

The escrow account system is designed to simplify homeownership and reduce the risk of missing critical payments, to protect both, the homeowner and the mortgage lender. The initial escrow amount is calculated to ensure your escrow account has enough funds to cover upcoming property tax, insurance payments, and a legal cushion for unexpected increases. This calculation accounts for the due dates of your bills and ensures you are not overcharged, thanks to the aggregate adjustment. 

If you prefer not to have an escrow account, ask your lender about their policies when you apply for a mortgage. Even if it is initially required, you might be able to cancel the escrow account later (after building equity and/or demonstrating financial reliability), depending on your lender’s terms and your loan type. If you need additional guidance regarding your escrow account please reach out to me at 312-296-4175 or email me at connect@borislending.com. I lend in all 50 states and I am never too busy for your referrals!!