Escrow Accounts: Who Needs Them & Why

Okay, okay, I’ll be the first to admit it...the real estate finance industry sometimes goes a little overboard when it comes to making up its own jargon. “Escrow” is one of those terms. Before I got into Real Estate I don’t recall a normal conversation ever requiring that particular term. But lenders not only use the term, they want you to have ‘em. In fact, they want you to have at least two months’ worth before you close on your new house.

Two months’ worth of escrow, that is.

Escrow accounts, or for those in California, impound accounts, are established by the borrower when first obtaining a new mortgage loan. Each month, when a borrower makes a mortgage payment, it includes mortgage interest, mortgage principal and two other items: Property taxes and hazard insurance.

For states where taxes are paid annually, each mortgage payment will include 1/12th of the owner's annual tax assessment. When it comes time to pay the property taxes, the lender, who keeps these payments in their very own cookie jar, pays such taxes when due. Likewise, when hazard insurance premiums are up for their annual renewal, the borrower has saved up enough money in the escrow account to pay for another year’s coverage. With escrow, the homeowner never has to wonder if their property taxes are paid or if their hazard insurance is in force. Escrow accounts take care of that for them.

But why have escrow accounts in the first place? Why can't owners just pay their own property taxes and hazard insurance?

From an actuarial standpoint, loans with escrow are believed less likely to default than loans without them. At years’ end, tax defaults won’t occur if taxes have been accruing in a lender’s account, something which might surprise borrowers who haven’t saved enough money to pay their annual tax requirement.

Most homes bought with less than 20 percent equity require the establishment of an escrow account as a condition of the loan. If you can place a bigger down payment on the property, perhaps because you're moving up to a replacement home and have cash from the sale of your current residence, then establishing an escrow account is usually an option.

But even with more than 20 percent down, lenders are so convinced that escrow accounts are good for you (and them) that they may pay you to have them. On the West Coast for example, it's not uncommon for lenders to offer consumers a bonus equal to 1/4 percent of their loan amount if they decide to establish an escrow account. In other parts of the country, lenders may take the opposite approach and make you pay extra if you DON’T set-up an escrow account. Either way, lenders like them.

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