I just checked the balance on our mortgage to make sure this month’s payment went through. I’m excited about accelerating our mortgage payments and seeing the principal decrease. We’re still waiting on first-time homebuyer’s tax credit, and will be using that $8,000 to take a chunk out of our mortgage.
While looking at the breakdown of our most recent payment, I noticed that about 20% went towards our escrow account. Having never had a mortgage before, I was curious to find our more about escrow accounts and decided to check out the Housing and Urban Development website to get more information.
Our lender had us pre-pay the first year’s premiums for our homeowner’s insurance policy. Going forward, our payment also includes an allocation for our future insurance premiums as well as our property taxes. This money is deposited into an escrow account.
What is an escrow account?
When you purchase a home with a mortgage, lenders typically add certain stipulations to protect their investment. One of the main things that they’ll do is require you to pay into an account that is used to cover the insurance premium and property taxes. That way they can be 100% sure these things get taken care of.
The amount that a lender can require a homeowner to put into the escrow accounts is limited by the Real Estate Settlement Procedures Act (RESPA). More specifically, they can only maintain a cushion of 1/6 of your annual escrow payment. After making annual payments out of the escrow account, any surplus over $50 has to be returned to you within 30 days.
Estimating escrow payments
If you’re a numbers type person, you can get an idea of what your escrow payments should be by following HUD’s formula:
- List all your annual obligations that will be paid out of your escrow account
- Don’t forget to include flood insurance (if applicable), which may only be due every 3 years
- Divide the sum total by 12 to arrive at your monthly obligation
- Add in two month’s of escrow payments to allow for the RESPA cushion limit
This should give you a good feel for your maximum required escrow total. If you feel that your lender is taking too much for escrow payments, contact them to receive an explanation on the difference.
Advantage of escrow accounts
Aside from providing your lender with a measure of protection, escrow accounts can be a very convenient way of taking care of, and budgeting for, your tax and insurance obligations. Having a large property tax bill show up unannounced can ruin your budget, and having an escrow account relieves you of this possibility.
It’s also worth noting that, even if there is an error with a payment from your escrow account, you have some protection. If your county sends a letter to you because your property tax was paid late, for example, you should forward a copy of that to your lender because they’re responsible for the penalty.
Downside of escrow accounts
While having your property tax and home insurance premiums handled automatically can be convenient, there can be a downside. For the financially savvy, escrow accounts can have a big opportunity cost, as could be stashing away that money yourself in a high interest savings account. In theory, you could tuck away 1/12th of your insurance and tax bills every month and then pay them yourself.
After all, most of use handle our life insurance and car insurance premiums on our own. Why should homeowner’s insurance be any different? In this day and age of online bill pay, escrow accounts can seem redundant from the consumer’s perspective. Not only are you losing money in the form of unearned interest, but you’re also ceding control.
In the final analysis, I think that an escrow account is a handy tool — and if you have a mortgage, you probably don’t have a choice in the matter. What do you think? Either way, we can’t wait to pay off our mortgage, and we’re focusing on that goal.