If you're planning to buy a home in the near future, real estate taxes and homeowners insurance are necessary carrying costs you incur as a homeowner. There are two sides to the coin when electing to have these expenses rolled into your mortgage payment. Here's what you need to know about mortgage escrow accounts:
How escrow accounts work
When you own real estate, you are responsible for paying property taxes and hazard insurance. These costs can be paid for separately by you, or can be included in your monthly mortgage payment, assigning payment responsibility to your lender.
Generally, when you buy a house with less than 20% down, it's a lending requirement to have taxes and insurance built into your monthly mortgage payment. The same rule also applies when you refinance your home with less than 20% equity.
When you are working with less than 20% equity -- or perhaps you might have more than 20% equity and you just choose to have taxes and insurance built into your payment -- creating an escrow account increases the amount of cash you need to close. The lender has to account for future months of property taxes and fire insurance that are not yet due, effectively building a savings account from which property taxes and insurance payments are paid.
Real estate taxes are due twice per year, with installments due in December and April. Homeowners or hazard insurance is due based on however frequent your policy states, usually annually or semiannually. The biggest factor in the creation of the escrow account is for the collection of real estate taxes, which far outweigh in terms of dollars what any insurance premium is. The lender collects the money at closing, building the reserve account for future payments of taxes and insurance. As you make loan payments over time, a portion of each payment goes toward crediting the escrow account balance with the lender. This escrow balance grows and accumulates in order for there to be enough monies to pay the taxes and insurance.
Why you will owe more at closing
When you're establishing an escrow account (also known as an impound account), you will owe more "cash to close" at the closing. Estimating six months of taxes and insurance is a good benchmark to use when determining how many extra dollars are due at closing.
In actuality, lenders will collect for different amounts of taxes and insurance based on whatever time of the year your closing is taking place. For example, if you're buying a home at $475,000, real estate taxes based on 1.25% of the purchase price would calculate to $5,937.50. This figure breaks down to $494.79 per month. Let's say your hazard insurance premium is $780 per year, which accounts for $65 per month. Taking six months of taxes and insurance, that's $3,358.74 due at closing in the establishment of the escrow account.
Taxes and insurance are recurring closing costs, meaning they recur each month as an ongoing housing expense. Nonrecurring closing costs are the one-time fees you pay at closing independent from taxes and insurance -- such as a processing fee, loan origination fee, or title fee. The challenge consumers sometimes face is that the money for the escrow account can make it appear as though their closing costs are much higher. That's not the case, but rather the money is needed for the establishment of the escrow account itself.
What to know about getting an escrow account
If you're thinking about opening a mortgage escrow account, here are five things to consider:
1. Qualifying remains unchanged
If you elect to not have taxes and insurance built into your mortgage, how the lender qualifies you remains unchanged. The mortgage company is going to have to take into consideration the mortgage payment, taxes, and insurance, as well as your other credit obligations against your income when determining your ability to repay.
2. Rates and fees remain unchanged
When you elect to have taxes and insurance built into your mortgage payment, expect no pricing perk on conventional and government mortgage types. With the exception of jumbo loans that offer a small pricing benefit -- usually of about 0.125% of the loan amount -- there is generally no additional benefit to having the taxes and insurance built into your mortgage payment other than convenience.
3. Refund when refinancing
When you refinance a mortgage that contains an escrow account, in almost every instance you'll be receiving whatever money is left in that account. Expect this refund check within 30 days of closing. If your new loan is established with an escrow account, this money will be due at closing in the form of cash, or it can be financed into the loan amount.
4. Closing an escrow account
Getting rid of your escrow account can usually be accomplished once you accumulate 20% equity, whether you're refinancing or not. Remember, if you have 20% equity, it's your choice to have a mortgage escrow account for the payment of taxes and insurance.
5. Annualized escrow rebalancing
Each year, your loan servicer will perform an escrow analysis to make sure the escrow account monies do not have a shortage or an overage in the account. If there is a shortage based on, for example, your property tax basis changing, or a change to your fire insurance policy, the servicer will contact you to collect the shortage difference. Also, your payment could rise by the amount of the shortage. If there is an overage in the account, meaning the lender has overcollected, they would refund the difference.
If you are undecided about whether to have a mortgage escrow account, and are working with 20% equity, plan on going the direction that allows you to most comfortably plan for the mortgage with your other household living expenses. For some, that means not worrying about it and having the taxes and insurance built into the mortgage payment. For others, it's having more choice and control over their money. First-time buyers, especially, would probably be better served having the taxes and the insurance built into their mortgage payment to help acclimate them to a new housing payment.
When you are shopping for a home, it's important to keep these costs in mind and to be sure you budget pretty generously for them so your finances don't take a hit should either of the costs go up. You can see how much house you can afford by using an online calculator. Before you apply for a mortgage, you should check your credit scores -- you can do that for free through Credit.com.
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