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The Importance of Escrow in a Mortgage

The Importance of Escrow in a Mortgage
4 min. read

Image: GaudiLab / Shutterstock.com

If you’ve just bought a house, you might be thinking that you were done with ‘escrow’. However, if you’re taking out a mortgage, it’s likely that you’ll meet escrow again, though in a slightly different form. An escrow account is often part of your mortgage and is something you should pay attention to. Here’s why.

What is a Mortgage Escrow Account?

An escrow account is a useful tool that is normally set up by your lender. Its main purpose is to store funds that will be used to pay for important property taxes and home insurance. These annual payments are essential, and missing them can lead to severe penalties.

How Does an Escrow Account Work?

Each time you make a mortgage payment, a portion of the funds will be stored in the escrow account. Over the year, they add up and by the time your tax and insurance payments are due, there should be enough to cover the costs. If so, the payments will automatically be made from your escrow account to the relevant parties.

However, as property taxes and insurance payments can change from year to year, you’ll find that the amount you pay into your escrow can fall and rise each year. The funds that are deposited into your escrow account are normally estimates that are based on previous years.

This means that sometimes you’ll have too much money in your escrow account, and other times you may fall short of the required payments and have to top it up. In case you’ve paid too much, you’ll be refunded the difference. But if you have to top it up, you’ll be required to pay a lump sum from your own finances.

Do You Need a Mortgage Escrow Account?

Whether you need an escrow account or not depends on your lender. In some cases, they may make it mandatory. In other cases, you might be able to opt out of it and take care of tax and insurance payments yourself. This will lower your monthly mortgage payments, but you will still need to pay a lump sum annually.

Normally, you can only opt out of an escrow account if you meet strict requirements that relate to your down payment, credit score, and type of mortgage. For most conventional loans, you will need to have paid at least a 20% down payment. Meanwhile, FHA loans require all borrowers to have an escrow account. In the case of VA loans, you’ll typically need a strong credit profile and should have put down at least 10%.

The Advantages of an Escrow Account

There are many advantages to having an escrow account that help keep you protected from problems further down the line.

No Chance of Missing Payments

As a homeowner you’re responsible for taking care of a huge number of payments, subscriptions, and a wealth of other tasks. So, it’s all too easy to forget something now and then. However, missing insurance or tax payments can have dire consequences.

The penalties for repeatedly missing home insurance payments can include: cancellation of coverage, the lender foreclosing the home to protect their investment, a negative impact on your credit score, and higher premiums in the future. Missing property tax payments can incur severe penalties and fines, and can lead to tax authorities putting a lien on your home and eventual foreclosure.

With an escrow account, homeowners don’t have to worry about missing payments, as the escrow service will take care of it for you. They will even make up the difference if your account is short, though you will be required to pay this back.

Payments Are Spread Throughout the Year

If you choose to take care of your tax and insurance payments yourself, you’ll have to pay one lump sum each year, which can be difficult to manage. With an escrow account, the costs are spread throughout the year and simply added to your existing mortgage payments, making it much easier to manage.

Lenders Are Protected

Escrow accounts are often mandatory as they’re extremely effective at protecting the lender’s investment. For example, if you miss insurance payments and aren’t covered when disaster strikes, there’s a chance you won’t be able to pay to resolve the issue. This leaves the lender with a foreclosed property that is not only damaged, but most likely also has liens on it.

Are There Any Disadvantages?

The main disadvantage of an escrow account is that it means higher mortgage payments that can fluctuate due to increases in your property taxes. Additionally, if your escrow service underestimated the costs and your escrow funds are short, you’ll be required to pay a lump sum of cash to make up the difference. This can be common in the first years of homeownership, as property taxes can rise considerably.

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