What is Escrow?
Escrow refers to the handling of funds used to pay your homeowners insurance and your real estate property taxes. Every home loan lender requires a home to be covered by homeowners insurance, as it protects their collateral. As you can imagine, most lenders have a strong interest in ensuring that their customers are maintaining their insurance coverage. Without it, a fire, severe storm, or even a leaky pipe could jeopardize the value of the home as collateral! Property taxes are a must. Lenders know that property taxes always have to be paid, and if they aren’t then tax liens are placed on the property, which supersedes the lenders lien on the home. It’s all about protecting the lender’s collateral, and with foreclosure rates so high today, who can blame them?
In most cases, you can choose whether or not you want to escrow. If you do escrow, then your taxes and insurance will be paid out of an escrow account funded by increases to your monthly mortgage payment. Essentially, your mortgage has principal and interest, and then you can add to that a monthly breakdown of your projected tax and insurance costs. As you make your monthly payments, the escrow portion is set aside in an escrow account until it is time to pay your taxes and insurance (taxes are paid usually annually or semi-annually, and homeowners insurance is often paid yearly in advance). If you do not escrow, then you will be responsible to pay these costs on your own when the time comes. Since this is essentially a more risky move for the lender, choosing not to escrow will more than likely lead to a higher interest rate than if you were to escrow.
Keep in mind that whether or not you choose to escrow, your lender or broker will account for the monthly cost of your taxes and insurance in your DTI during underwriting. They have to account for that expense, and do so via a monthly representation. Also keep in mind that if you do escrow, you will likely have higher initial closing costs. Technically, these are not closing costs, as they are not purely associated with closing your loan. These are considered pre-paid costs, similar to interim interest when you close. At the time of closing, an estimate will be made as to how much you would need in your escrow account at that time to be on track to pay the due amount at the next installment, assuming you had just the remaining months of payment to pay into it. For example, if you close in April, in most cases your first payment will not be until June 1, so this would be the first time you paid into the escrow account. If your taxes are due semi-annually, and the next installment is due in July, then you need 6 months worth of taxes to pay, but only one month of payments! Due to this, at closing, the title company would likely collect five months of escrow reserves. This is paid at closing and ensures that you’re caught up and on schedule to pay as needed. During a purchase transaction, this is sometimes covered in part by the sellers current escrow balance. You can also arrange this to be part of the closing costs paid by the seller if you have negotiated that into the contract. In a refinance, you could potentially roll these costs into your new loan, if you have adequate equity to do so.
It is important to note that property taxes and insurance premiums can change from time to time. When this happens, your mortgage company will adjust your escrow requirements to compensate and ensure that you’re covered. When this happens, it will most likely affect your overall mortgage payment. If your taxes go down, then your needed escrow payments could go down, thereby leading to an overall lower mortgage payment every month. However, if those amounts increase, then the opposite is true.
All in all, it seems that most home loan borrowers opt to escrow, simply because it is out of their hands and automatically built into their monthly budget as a part of their payment. And the lower rate doesn’t hurt either! Those who choose not to escrow often do so because they prefer to be in control of their funds, and perhaps wish to invest those dollars in the interim. Either way, there are pros and cons to both, and you just need to be aware of the ramifications of each option, and what will be expected of you.
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