Understanding Escrow Accounts
What you need to know about escrowing taxes and insurance when purchasing or refinancing a property and everything in between
When I speak with individuals about the escrow portion of their closing costs there are often questions about how the amounts needed for escrow are determined- especially with a refinance. Escrow Accounts can be tricky for some to understand mathematically, so I hope this information can help you take away a little more information regarding escrow amounts: how they are calculated, what to expect, and an effective strategy to handle the escrow balance when refinancing.
An Escrow Account, also referred to an “impound” account, is a side account where taxes and insurance are collected for the purpose of paying your Homeowners Insurance, Property Taxes, and flood insurance (if flood insurance is required). As you make your monthly mortgage payment, the escrow portion of your payment is stored in this side account. When insurance and taxes are due, your mortgage servicer will debit the money out of this account and pay your insurance provider or tax authority accordingly. Your Mortgage Servicer or Bank prefers to do this for you so they can guarantee your property is never uninsured or encumbered with a tax lien. In fact, escrow accounts are required by most banks and mortgage servicers if your Loan Amount is greater than 80% of your property’s value. If you have flood insurance, as of January 1, 2016, it is required to be paid in an escrow account regardless of your loan to value ratio. In most cases, you will also get a better rate/fee combination on your mortgage loan if you agree to escrow your taxes and insurance.
Purchasing a Property - Escrow Reserves When purchasing a property, part of your required closing costs is to create reserves for your new escrow account. This is because the amount you pay in Insurance and Taxes is not static, it is likely to increase with time. To help avoid escrow shortages, when purchasing a property, it is a standard mortgage practice to pay two months for reserves and often one additional month since you would not have a mortgage payment the month following close. The goal of the servicer is to always maintain a proper balance within the escrow account. Money for escrow is never considered a mortgage related investment. It is your money, in a side account, prepared to pay insurance providers and tax authorities as required.
Refinancing a Property - Escrow Balance + Reserves
When you refinance a property part of your required closing costs is to create a new escrow balance for your new mortgage servicer PLUS two months reserves. Keep in mind, this is not considered investment into your refinance. It is to ensure a proper balance based on your due dates.
Example: Taxes and insurance are both due in December. Your refinance closing date is in March. The lender will collect six months of taxes and insurance: Jan, Feb, March + 2 months reserves + 1 for skipped payment
Your escrow balance with your current mortgage servicer is refunded to you in full within 30 days of close. Your refund should be similar to the collected amount, assuming your reserves were not depleted minus the one additional month collected for your skipped payment.
In a simple world, it would be easier if the balance were transferred, but your new servicer must ensure that your escrow balance is true and accurate.
Here are some options and tips on dealing with the escrow account during a refinance to help mitigate any loss:
Pay your new escrow balance out of pocket and wait for reimbursement from your current mortgage servicer. This will keep your minimum monthly payment the lowest.
Roll the escrow balance into your new loan amount and wait on refund. Remember this is borrowed money and not free- so if you keep it, you are financing the escrow account. Which leads me to advise most to handle escrow refunds with the third option:
When you receive your escrow refund, apply it as an additional principal payment to your mortgage. In most cases, this will reduce your term by several months.
Use lender credits to help mitigate escrow needs. I typically do not recommend this. However, in rare short-term lending- this could prove to be beneficial.
The big take away with escrow accounts is that there are never investment related costs to the escrow account itself. Mortgage servicers are under strict regulations to protect your money and to make sure it is handled effectively.
If you’re like me and want to know the finite details, you can read more on the regulations here: § 1024.17 Escrow accounts.
If there are any parts of escrow that still seem to be a mystery, don’t hesitate to ask- that’s what I’m here for.