To Escrow or Not to Escrow
People that are preparing to buy a home or refinance an existing mortgage find themselves in a position to research and ask multiple questions about the pending loan. One of the questions that pop up frequently concerns escrow. Should a person use an escrow account or control the funds for the insurance and taxes on their own? The answer, unfortunately, is not as clear cut as the question.
The Basics of the Escrow Account
Certain loans may require an escrow account for the borrower. However, for buyers that pay at least 20% down or for people refinancing up to 80% of their home’s appraised value utilizing a conventional mortgage (Fannie Mae or Freddie Mac), they will have the option to either use the escrow or handle the money on their own. For those purchasing or refinance through a government program (FHA, VA or USDA), an escrow account is required regardless of the loan to value.
With an escrow, the annual amount for homeowner’s property insurance as well as the taxes on the home are divided into 12. Furthermore, many escrow accounts may also ask for an extra reserve to handle any changes or potential shortfalls.
Here is a typical example. A married couple buys a home that has annual property taxes of $4,200 and the insurance on the home is $738. Those two numbers added together are $4,938 and then divided by 12 equals $411.50. The lender may ask that an extra $400 be added to the total account balance in case the value of the home goes up or a change in the insurance causes the premiums to rise. Thus, the overall escrow payment would be $444.83 per month on top of the mortgage payment.
For individuals without the escrow account, the $4,938 would need to be paid out of their pockets at the end of the year.
The vast majority of home buyers are eligible for an escrow account. However, if you decide to pay the insurance and taxes on your own, then you are effectively waiving the right to use the escrow. Lenders see this as a slight risk and will charge the borrower a fee, or could even modify the interest rate on the loan. This will prevent you from getting the absolute lowest rate for your mortgage. If you do choose to waive the escrow it is possible to pay the extra charge up front, which will do away with the rate modification.
Do you have Saving Habits?
If you are the type of person that always stashes away part of your earnings in case of a rainy day, then you may be fine handling an escrow on your own. People that are accustomed to waiting to get what they want and stick to a budget are usually the best candidates to go without an escrow.
However, if your tendencies lean more towards spending and you seem to feel that cash in your pocket is simply a temptation to spend, then you may wish to take advantage of the escrow account.
The reasons for using an escrow make sense for spenders. First, spenders may forget to save enough to cover all of the insurance and the taxes. If the taxes are paid too late, it can lead to legal problems. If the insurance is paid late and there is damage to the home, the repair costs may not be covered. This would mean even more money out of pocket for the homeowner.
If the homeowner has not saved for the taxes and insurance they could feel pressured to borrow the money. Borrowing the money on a credit card or an unsecured loan would result in a high interest pay back. This would mean that they are now paying interest on money that was supposed to be saved during the year.
On the flip side, some people have income fluctuations and they know that they will receive a large amount in commissions or bonuses at certain times of the year. For those people, it could be a good thing to pay the escrow yearly on their own as long as the extra money is available.
Making the Money Work for You
If you do have good budget and spending habits, saving the money can actually allow the funds to work for you.
For short term savings that will need to use the funds in one year or less, many experts suggest taking advantage of money market accounts or a certificate of deposit at their local bank. While these accounts do not have a high rate of return, they will at least earn some interest.
Some people with a high tolerance for risk may choose to put the money in stocks or bonds. However, it is important to understand that the reward may be high but the risk is also quite high.
Changes in Closing
If you choose to waive the escrow account be sure to tell your mortgage lender well in advance of the closing. The closing agent or closing attorney will need to calculate how much funds are necessary for you to bring to the closing since it will be your responsibility to pay any due taxes if you are refinancing. Furthermore, if you are buying a home you will need to provide money to pay for the first year’s insurance policy for the home.
Shift in Responsibility
As long as you are using an escrow account the lender is solely responsible for paying the annual insurance premium as well the taxes on the property when these bills come due each year. If for some reason the lender is late paying the bills then it is the lender’s responsibility to make any late charge or penalty payment, not you.
However, that responsibility shifts to you if the escrow account is not used. There is no blame assigned to the lender if you fail to make the payment to the proper tax assessor or to your homeowner’s insurance agent. In some instances, people have failed to pay the property tax and later learned that a lien was placed on the home. This could cost lots of money to repair.
Once again, for people that have a long track record of managing their money and preparing for the future, waiving an escrow account is no big deal. They can handle saving the monthly amount and have no issue writing the check for large purchases when the yearly bill shows up in the mail. It really comes down to your habits and your comfort level.