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.

What does it take to establish an escrow account? Federal rules allow no more than two months’ plus $50 at loan closing for a new purchase. This money -- which is kept in the account in addition to the monthly payments made by borrowers -- is used to establish the account and is there in case there is a shortage at years’ end. This can happen because during the course of a tax year your local government may be hard at work changing the tax rates or your school taxes might increase. In such cases, those regular payments you've been making may not be enough to pay for local taxes and insurance coverage. The two months’ escrow account acts as a “cushion” to soften the blow of higher-than-anticipated annual tax bills come due.

Where does the Lender get the tax information in the first place?

Local guidelines vary, but typically it comes from the title company, which obtains the tax data from the various assessing agencies. One needs to exercise a little caution here for new construction, however, when compared to an existing home.

The property value of most existing homes can be established from the local property appraisal or assessment board. But with new construction, the assessment may not reflect the “improved” portion of the lot; that is, your house. An unimproved lot, or vacant land, will carry a much lower assessed value which will then result in a lower tax bill. An improved property will carry a higher appraised value, and therefore a higher tax bill. If you go into closing on your new home, check the tax rate and see if the tax is for improved or unimproved property. If the rate is for unimproved, you may be in for quite a surprise at tax time when you discover your lender only collected for a vacant lot, not for the full tax amount.

Ask your new-home lender to estimate the taxes for the upcoming year and have them collect on that. Otherwise, you could be in for a shortfall of several thousand dollars, all the while thinking your taxes have been paid and accounted for.

Are escrow accounts a good thing?

Just like anything else, it depends. If the borrower feels comfortable paying taxes on their own, and if the loan does not require the estblishment of an escrow account, than the same funds that would normally be placed in escrow could be put to work elsewhere, perhaps in a money market account.

Alternatively, if you like the security of knowing that your taxes and insurance will be paid on time, every time, then go for the escrow account. The lender will be pleased and you won't have to worry about writing big checks when taxes and insurance bills are due.

Published: January 18, 2001

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