Understanding Your Mortgage Loan Escrow Account and Impound Payments
In the residential mortgage loan industry, the escrow—or sometimes called impound—account is a tool used by the lender to ensure that your property taxes and insurance (hazard, flood and mortgage) premiums are paid on a timely basis.
The escrow account essentially allows the lender to control your monthly payment of these housing expenses. As discussed below, the escrow account can be waived or, in some areas, replaced by a pledged account. However, most homeowners prefer to maintain an escrow account, as it makes tax and insurance payments more convenient.
The basic reason why lenders are so paranoid about payment of these items is simple risk management. The failure to pay taxes and insurance could mean major losses for the mortgage lender, making escrow requirements crucial to the lender.
A discussion of how the escrow account operates and alternatives to escrow accounts are included below.
But first, this article will review the three elements from the typical housing payments included in most escrow requirements:
- Real estate taxes
- Hazard insurance
- Mortgage insurance
Real Estate Taxes
Why should mortgage lenders worry that real estate taxes are paid on time?
Real estate taxes, for one, record liens against the property. In fact, tax liens normally supersede any other mortgage liens — regardless of chronology.
Remember that property liens are normally recorded and empowered in chronological order. In the event the property is sold, the first lien must be fully paid before any funds can be used for the second lien. First mortgage loans normally occupy primary the lien position against the property. However, these and all other commercial liens are superceded by real estate tax liens.
If real estate taxes are not paid, the county or taxing authority does have the right to pursue collection and, eventually, foreclosure action against the property owner.
In many locales, the taxing authority will auction past-due tax bills to third parties, who specialize in tax foreclosure sales. If the property owner fails to satisfy these tax bills within the redemption period, the subject property will legally and officially be transferred to that third-party investor.
Consequently, someone can purchase a past due tax bill of $5,000 on a $100,000 home and eventually take ownership of that property. With such a tax foreclosure, the mortgages on that property are released without any compensation to the mortgage lender.
As you can see, lenders do not want to deal with such foreclosures and tax sales. If the home is going to be foreclosed, common logic dictates that most lenders would rather be in control of that situation.
By including real estate taxes in the escrow accounts and mortgage loan payments, your mortgage lender will be less worried about the possibility of a tax foreclosure.
Hazard Insurance
We discussed why lenders are likewise concerned about the payment of homeowners (hazard) insurance premiums in the Hazard Insurance chapter.
Hazard insurance coverage is very important for lenders, because it protects the lender’s security, or mortgaged property. For example, if a lender provides a $95,000 loan on a $100,000 property, it knows that there is relatively sufficient security for their loan. However, if that same property burns down with no hazard insurance coverage, the property securing the loan is only worth the approximately $20,000 lot on which the rubble remains.
In such cases, the lender is left holding a $95,000 loan secured by a $20,000 property. The reverse side of this coin is that homeowners in that predicament would be sorely tempted to walk away from such a situation and accept the foreclosure: they give up a $20,000 piece of land to erase a $95,000 debt.
Mortgage Insurance
Mortgage insurance, when applicable, is also important for the lender as it protects them against potential losses in case of borrower default. Most lenders figure that the most they can recoup on a typical foreclosure action is 60%-80% of the property’s true value (although the recent foreclosure crisis has been challenging this assumption).
Foreclosure sales usually result in homes selling for only a fraction of their real value. When you subtract from that sales price all legal, real estate brokerage, administrative and court fees, you quickly see why lenders hate foreclosures. In addition, there is also the issue of past due interest and late charges.
So if the loan is greater than that net level the lender receives after all foreclosure costs are settled, the lender loses money. With mortgage insurance, the lender is able to recoup much of those losses.
It may seem unfair that you’re paying the premiums on a mortgage insurance policy that protects your lender. But the truth is that mortgage insurance lowers the risk of residential lending and makes low down payment mortgage loans possible.
Escrow Mechanics
At the closing, the homebuyer will establish an escrow account with the lender by providing two or three months of property tax and insurance premiums. These initial deposits are established as buffers and because, in most cases, the first monthly payment into the escrow will not be for another 30-60 days.
With each monthly mortgage payment, you will also include monthly portions of the real estate taxes and insurance premiums. When the real estate tax bill arrives, the lender’s escrow account manager will also receive a copy and pay that tax bill with funds from the escrow account.
Likewise, the lender will pay the insurance premiums as they become due. The initial escrow deposit for insurance premiums is in addition to the full year’s insurance coverage that the homebuyer must purchase prior to the closing. This may seem a case of overcharging until one considers that the lender just wants to be sure that when the time comes for the insurance to be renewed, there will be funds in the escrow account for that purpose.
You are the party liable for the taxes and insurance premiums. The lender absorbs none of that obligation with the escrow account; they just safeguard it. As inflation and other issue raise property taxes and insurance premiums, the lender will be notified and pass these increases on to you.
Most escrow accounts are interest-bearing, and your account must be credited with any such interest income, less administrative fees.
When the loan is refinanced or paid off, the lender will return any remaining balances in the escrow account to you. Most lenders do this in one of two ways. The lender will either reduce the payoff requirement with the balance in the escrow account; or the lender will hold the escrow until the refinance or payoff is complete and then mails the balance to the erstwhile borrowers.
Escrow Alternatives
The mortgage industry and some locales provide you with alternatives to the escrow account. In fact, many property investors prefer to avoid escrow accounts as it ties up their liquid assets in low-earning accounts and inhibits centralization of tax and insurance payments.
For the average homeowner, the primary alternative is the escrow waiver. This option is available when the homebuyer makes at least a 25% down payment. The lender will charge an escrow waiver fee, usually about $250 or 0.25% of the loan amount, whichever is greater. You still have to pay taxes and insurance premiums. However, you will do directly to your county and insurance company..
In some areas and programs, you will have the option of pledging a savings account in lieu of maintaining an escrow account. That account must maintain a minimum balance at all times. Again, you still have to pay taxes and insurance premiums; however, he or she does so without lender intervention.
With either of the above alternatives, the lender does have certain rights and protections. If you fail to make tax and insurance payments as required, the lender has the right to re-impose the escrow account.
Most non-conforming loan programs tend to waive escrow automatically, preferring not to deal with it at all. This is especially true of non-conforming programs that require at least 10%-20% down payment. Instead, they sometimes offer you the option of maintaining an escrow account.
For most homeowners, especially first-time homebuyers, the escrow account’s benefits of efficiency and convenience, outweigh their relative costs.
Go to next HomeBuyer Guide chapter: “21. Down Payment Options”
