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FATW: How Do Escrow Accounts Work?

what are escrow accounts

Found Around the Web: The Paycheck Chronicles Discusses Escrow Accounts and How They Affect Your Mortgage Payments

And to think, I've been running a Military Finance blog for a year now, focusing on mortgage above all else since it's our #1 area of expertise, and I've yet to touch on the topic of Escrow Accounts.  But that's kind of the nature of escrow accounts, isn't it?  They operate in the background, everyone kinda understands them, they're often overlooked, but heck, they can affect your VA Mortgage payment as much as anything, because most lenders require you to have one if you have a VA Loan.

#FATW Snapshot

  • SOURCE:                Paycheck Chronicles (Military.com)
  • TAGS:                      VA Mortgage, Home Ownership

FAVORITE QUOTE: "Mortgage escrow accounts are one of those things that are completely confusing until one day it just all makes sense."

COMMENTS:  Kate Horrell dives into a rather mundane topic that is important to understand without boring you.  So, thanks Kate! This isn't just the "what" of Escrow Accounts, but also that "why" and "how", which I always appreciate.

Right on cue, Kate Horrell from military.com's Paycheck Chronicles has posted this short article entitled "Why Did My Mortgage Payment Change?" which I will summarize for you here.  You can also follow the title-link for the original post on her website.

Your "mortgage payment" is made up of 4 parts: Principal, Interest, Property Taxes, and Homeowners Insurance. All 4 elements will change over time, even if you have a fixed rate loan. Principal payments rise over time as interest payments shrink, and tax and insurance can both go either up or down depending on outside factors that have nothing to do with your actual mortgage. It's important to understand that.

What Is Escrow?

The majority of mortgages in the United States include an escrow account, which is a special type of bank account. In the case of mortgage escrow, this is a savings account that is used to pay expenses that are directly related to owning the home. Escrow accounts are sometimes called impound accounts. These typically include real estate taxes and homeowner’s insurance, but also may include things like homeowners’ association fees, flood insurance, or other expenses. When you have a fixed rate mortgage, the principal and interest portion of your mortgage payment doesn’t change, but the escrow portion of your mortgage payment may change each year (rarely, more often.)

This change happens for two reasons that are inter-related:

  • the actual amount of expenses paid from the escrow account last year were different from the amount anticipated, and/or
  • the anticipated amount of expenses for next year have changed from the previous year

~ Kate Horrell

Typically, when we are explaining Escrow Accounts to our clients, we are focused on the "up front" piece, or the establishment of the escrow account upon closing of the mortgage loan. Whether you are purchasing a new home, or refinancing your existing VA loan, the lender will require you to deposit a certain amount of money into your new "Escrow Account."  This amount typically consists of dollars allocated towards two homeownership related expenses: Property Tax and Homeowners Insurance (or Hazard Insurance, or Property Insurance, as it is sometimes called).  The amount that the lender will collect is not random; there is a specific calculation, and it will not vary lender to lender, but rather is a factor of when your first payment will be due to the lender and also when those payments (your tax bill and your insurance bill) are due to the respective interested parties.  The lender should always collect enough money to pay the debtor at the appropriate time while maintaining a two-month cushion.

What does that mean, and how do they calculate it?  Your annual (or sometimes semi-annual or quarterly) property tax payment and your annual insurance bill are divided into 12 equal installments (since you make 12 mortgage payments each year) to determine how much needs to be collected monthly on top of your principal and interest.  The due dates for each payment will be different because your city and/or county has set payment dates for taxes, while your insurance agent will bill you once a year on the anniversary of your policy's effective date. This is where it gets complicated: the lender has to determine how many monthly payments you will make before each bill is due (therefore telling them how much money they will collect as normal course of business) and subtract that number from the total amount due at that time, then collect the number of months that they would be deficient at your loan closing (+ 2 months cushion), to ensure they have adequate funds to pay those bills on your behalf.

Huh?

Ok, yawn and bear with me.  Let's look at an example, using stupidly round numbers for ease of understanding.

Let's say you are closing on your VA Loan Refinance in April, your $3000 in taxes are due on December 31, and you originally purchased your home in the month of September, so that's when your $1200 home insurance is due.  If you're closing in April, then your first mortgage payment will be due on June 1st.

  • Property Taxes: You will make 7 monthly payments from June to December.  $3000 divided by 12 is a $250 monthly amount. By 12/31, you need to have 12 months collected to pay the bill, plus 2 months of cushion--which is 14 months.  Since the lender will collect 7 payments naturally, they will need to collect another 7 months at closing to ensure adequate funds. This means you should expect them to collect (7 x $250) $1750 in taxes.
  • Home Insurance: You will make 4 monthly payments from June to September. $1200 divided by 12 is a $100 monthly amount. By September, you need to have 12 months collected to pay the bill, plus 2 months of cushion--which is 14 months. Since the lender will collect 4 payments naturally, they will need to collect another 10 months at closing to ensure adequate funds. This means you should expect them to collect (10 x $100) $1000 in insurance.
  • Your initial deposit into your new escrow account will be just under $1000+ $1750 = $2750.  Why less?  Because of a little voo-doo magic called an Aggregate Adjustment (which is a complicated formula lenders have to use to make sure they don't collect too much from you.  In practice, lenders collect what they believe to be correct, then give you a little back just to be safe).

Make sense? Great!  So why do we have to go through all of this?

As Kate does a great job of explaining, and as we've explained to clients ad nauseum over the last 10 years, it's all about risk management:

When a lender loans you money to buy a house, they need to protect their investment.   Because tax bills always take precedent over mortgage bills, the mortgage company needs to ensure that those tax bills are being paid.  Similarly, ensuring that necessary insurance coverage is maintained makes sure that the value of the home is protected if there is damage.  By paying the tax and insurance bills themselves, the mortgage company decreases their risk from unpaid tax bills or homeowners’ association bills or lapsed insurance coverage.

For more detail on how and why these amounts can change year to year, why there is always so much confusion about this topic, and how it all affects your payment, please visit Kate's article here.  Really, it all comes down to this: your mortgage servicer is a middleman in every sense of the word.  Your tax amounts can change at the whim of the county and even city; your insurance premiums could go up or down; you could choose to change insurance providers...and none of this is controlled by your mortgage company.  They just need to react to those changes and update your monthly payment accordingly to ensure payment of the correct amounts at the correct times.

 

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