In a home loan transaction, the lender commonly requires the borrower to agree to pay property taxes and keep homeowners’ insurance on the property. To make sure this happens, the mortgage lender might collect extra money from the borrower each month, along with the principal and interest. The lender puts this extra money in a special account called an escrow account (called an “impound account” in some states). When the property taxes and homeowners’ insurance bills are due, the lender pays these bills with money from the escrow account. Homeowners, however, sometimes prefer to pay the taxes and insurance themselves. Read on to learn more about escrow accounts and under what circumstances you might be able to cancel this type of account.
Why Is the Lender Worried About Taxes and Insurance?
From the perspective of the lender, a successful loan is one where the borrower regularly makes timely payments of principal and interest, until the debt is reduced to zero. But if the homeowner fails to make those payments, the lender has another way of getting paid. If the tardy borrower cannot work things out with the lender, the lender will sell the house at a foreclosure sale to satisfy the debt.
Hopefully, the sale proceeds will cover the outstanding debt. But a house whose taxes have not been paid will have tax liens on it—and the taxing authority will get paid before the bank. This may not leave enough money to fully cover the debt. Similarly, a house in good condition (because insurance money was available, for example, to fix damage after a fire) will bring in more money at a foreclosure sale than one left to fall apart.
By insisting that the borrower pay a little bit each month into a tax and insurance escrow account, and by taking responsibility to actually pay those bills, the lender is making sure that money will be available to cover these important costs, and that the payments won’t inadvertently be skipped.
How a Mortgage Escrow Account Differs from Escrow When You Buy a Home
A mortgage escrow account is a different kind of escrow than the type you had when you bought your home. Escrow that accompanies a home purchase is short-lived, and involves a neutral third party—an escrow agent, title agent, or escrow company. This agent holds funds, such as earnest money, or important documents, like the deed from the seller transferring the property to the buyer, before closing the sale.
Throughout the life of your mortgage, you of course pay the lender monthly amounts of principal and interest. If the lender has also set up a mortgage escrow account, you’ll also pay about one-twelfth of the estimated annual cost of property taxes and homeowners’ insurance each month. (Sometimes the lender will also collect amounts to cover homeowners’ association dues and mortgage insurance.) For example, if your property taxes and insurance add up to $6,000 a year and you have an escrow account, you’ll pay $500 each month in addition to your payment of principal and interest. The lender deposits this money into the escrow account. The lender then pays the tax bills and insurance premiums out of this account when the bills become due, usually once or twice a year. Because the cost of taxes and insurance can fluctuate from year to year, you might also have to pay some additional money into the account, usually two months’ worth of escrow payments. The lender can use this money—called an escrow “cushion”—to pay for unexpected increases in the property taxes or homeowners’ insurance.
Certain Loans and Lenders Require Escrow Accounts
If you have a certain type of loan or if your lender requires it, you must have an escrow account. However, you might be able to cancel the account at some point.
Conventional Loans: Escrow Accounts are Optional
With a conventional loan, the lender decides whether to set up an escrow account. In most cases, the lender will insist you have an escrow account if your down payment is less than 20% of the purchase price for the home. But, if you make a down payment of 20% or more, your lender might not require an escrow account. The reasoning behind the lender’s willingness to waive the escrow account is its belief that because you have relatively high equity in the house, you’ll be motivated to save enough money to pay the tax bills and insurance premiums.
If you can’t afford to put 20% down when you take out the loan, and don’t want an escrow account, you might be able to cancel the account once you reach 20% equity in the home. In most cases, you also must have had the loan for at least a year and cannot have any late payments during that time. If the lender cancels the escrow account and later finds out you haven’t paid the taxes or insurance, it will probably set up an escrow account for you at that time.
Federal Housing Administration (FHA) Loans: Escrow Accounts Required
If the Federal Housing Association (FHA) guarantees (insures) your mortgage loan, you must have an escrow account. With a FHA loan, if you breach the mortgage agreement and your house isn't worth enough to fully repay the debt through a foreclosure sale, the FHA will compensate the lender for the loss. Because the FHA wants to limits its losses, it requires escrow accounts on FHA-backed loans, to make certain the taxes and insurance are up to date.
U.S. Department of Veterans Affairs (VA) Loans: Escrow Accounts Usually Required
The U.S. Department of Veterans Affairs (VA) doesn’t specifically require lenders to set up escrow accounts on VA loans. However, the VA says that it is the lender’s responsibility to make sure that homeowners with VA loans pay property taxes and have homeowners’ insurance. So, to comply with this requirement, most lenders that make VA loans set up escrow accounts for borrowers.
Higher-Priced Mortgage Loans: Escrow Accounts Required
Under federal law, lenders must set up an escrow account if you take out a “higher-priced” mortgage loan. “Higher-priced” mortgage loans are, in general, loans with an annual percentage rate (APR) that is higher than the average interest rates, fees, and other terms on mortgages offered to highly-qualified borrowers. In most cases, the escrow account must continue for at least five years. After five years, you can cancel the escrow account if the unpaid balance of the loan is less than 80% of the original value of the property and you have no delinquent payments.
Why You Might Want to Keep—or Cancel—Your Escrow Account
It would be a mistake to automatically conclude that it’s always in your best interests to avoid or cancel an escrow account. True, your payments will be lower each month without one, but all in all, you might be better off with one. Consider the following points.
If you’re not good at setting money aside to pay large bills that will come due later, it might be a good idea to have an escrow account. Having an escrow account makes it easy to save money to pay the taxes and insurance, because you contribute small amounts toward them with each mortgage payment. Also, when you have an escrow account you don’t have to worry about forgetting to pay the taxes or insurance. If you forget to pay the property taxes, your state or local government might charge you a penalty or place a tax lien on your home. You could then face a foreclosure by the taxing authority (if it has a lien on your home) or by the lender (if the lender pays the taxes for you and you don’t reimburse the lender).
On the other hand, if you’re good at saving money, you might not want an escrow account. By putting the money in a savings account rather than an escrow account, you can earn interest until you have to pay the taxes and insurance. (Generally, the lender doesn’t have you pay you interest on money in an escrow account, although a few states require it.) If you decide that you’d rather pay the taxes and insurance yourself, contact your lender to see if you can cancel your escrow account.