The system of mortgage escrow accounts was created with good intentions. On the one hand it was to make the lender happy, because the lender got some guarantee that no lien prior to his own will be put on the mortgaged property through taxes or insurance, on the other hand, it was to save the borrower the pain of large lump sum insurance and tax payments. Everybody was expected to be happy, and that’s how it has worked for many people since, but sometimes even the best-laid plans fail.

Ideally, the system works as follows: when you sign your mortgage contract, among other things you agree to trust the property taxes and insurance to be paid by the lender with the money from your special set up for this particular purpose escrow account. Thus, in the course of your mortgage’s life, every period mortgage payment will need to contain a certain extra amount that is deposited into your escrow account. When the time comes, the lender takes the initiative and pays the taxes and insurance premiums in a lump sum using the money accumulated in the account. In other words, you, as a borrower, don’t have to pay the bulk money yourself, you save it gradually, thus making the big payment less painful. Just fine, you’d say, but why do I need the lender to do it for me, if I feel quite capable myself? It’s a fair question. One side of the story is your advantage, which is in the simple fact, that you don’t have to beat your brains out trying to remember when and how much of these actually very important payments you have to make. No other advantages for you, though. They are all on the other side - on the lender’s side. First of all, this way the lender makes sure that the property stays intact (or at least insured against damage) and free from any other lien but his. If the property taxes and insurance remain the borrower’s responsibility, there is always a chance that for some reason the borrower may fail to fulfill these obligations. If that happens, the tax authority, for example, may place a lien on the property that is higher than the lender’s lien. No lender would be happy with such a turn. Another a little bit less straightforward advantage is the interest on the escrow account money that the lender gets to keep to himself. It is usually not a huge amount, however it makes many people wonder if it’s a little bit too much of a present to the lender. Especially when they realize what kind of service they are paying for.

Now, about the original good intentions … The whole system has fallen victim to human greed. Not totally! There are a lot of responsible lenders who do take care of the escrow business properly. The sole purpose of my dramatic overstatement above is to draw your attention to a potentially very grievous situation you may find yourself in, if you don’t look into it in advance.

The problem is that escrow accounts are among the most abused, intentionally or accidentally, mortgage matters. The biggest abuse is a complete failure of the servicing agent to make any of the tax and insurance payments due. Sometimes because of unintentional carelessness, sometimes it’s a deliberate abuse, when the money is withdrawn from the account, but not paid. Just gone. The unaware borrowers may find out a couple of years later that their tax debt is about to cost them their home. When you sign a contract, you trust the other party to perform as agreed, especially in a matter as serious as a mortgage. A lot of borrowers trust their lenders too much and do not keep an eye on the escrow account activity. Even though this is exactly the idea of an escrow account, such carelessness puts their money or even their homes at big risk. So, what was that only borrower’s advantage? - Right. Nerve-racking 24/7 doubt.

Unfortunately, it is very hard to tell in advance if the lender will be honest and efficient servicing the escrow. If the lender services the account himself, you can talk to other customers in advance, read some reviews, but if the lender sells the servicing to some other servicing agent, which happens a lot, it is practically impossible to foresee the quality of service.

• taxes and/or insurance are not paid
• the account is charged twice
• taxes and/or insurance are underpaid
• tax and/or insurance payments are late
• monthly payment to the account increases unexpectedly

These are just a few of the most common problems that occur. Each of them is potentially very dangerous. You can never be totally sure that nothing of the kind is happening to you, but you can try and keep things under control to minimize the possible damage:

• How much is a monthly escrow payment? Before you buy a house, contact the county property appraiser and tax collector to find out how much the fully assessed property taxes will be, as well as an insurance agent for an estimate of how much your homeowner’s insurance premiums will be. Find out about other payments to be placed in escrow. You need the numbers to estimate the extra amount to be added to your monthly mortgage payment as escrow. To calculate that, you sum all the tax and insurance premiums to be paid within the 12 months following the closing date, and divide the result by 12. For example, taxes - $600 paid July 15 and $780 paid December 13 and hazard insurance - $300 paid September 10 add up to $1680. Divide this total amount by 12 (number of payments in a year). $1680 divided by 12 = $140. This is your monthly escrow payment. However, the tax and insurance payments come due quite unevenly throughout a year. It may well so happen that a large payment is due in the very beginning, when the amount accumulated in the escrow account is not enough yet to cover it all. In this case, the lender pays your taxes in full on time and then gradually returns his money as you refill the account with your new monthly payments. The balance for a year looks something like this:

I strongly recommended you try and create a trial year balance like this one for your particular situation. If you live in an area where, for instance, flood insurance is due every 3 years, the trial balance has to include all the three years for an accurate result. Why is a trial balance so important? It gives you information about the month, where the balance is the lowest - in our sample case it is December. As you can see from the table above, the balance is actually negative all the way. Now, we cannot possibly expect the lender to be as generous as to pay everything in advance using his own funds, can we? The lender’s solution to the problem is a financial cushion that he requires you provide for him. Section 10 of the Real Estate Settlement Procedures Act (RESPA) limits the amount of money a lender may require the borrower to hold in an escrow account for payment of taxes, insurance, etc. The RESPA statute and regulations do not actually require the lender to maintain a cushion, which sometimes lenders claim it does. However, the RESPA allows lenders to maintain a cushion equal to one-sixth of the total amount of items paid out of the account, or approximately two months of escrow payments. Note: if state law or mortgage documents allow for a lesser amount, the lesser amount prevails! For our sample escrow account with its lowest -$840 in December, the cushion will be: $840 (to make sure the balance does not drop below zero) plus $280 (1/6 of the total escrow charges, i.e. 1/6 of $1680 = $280) = $1120. The cushioned balance will look like this:

In this example, $1120 is the maximum amount the lender is allowed to require in the account. The account should fall to the cushion at least once during the year. In this example, it happens in December ($280).

• Note that the next year’s payments can be different. There is always a chance that some taxes and/or insurance premiums will go up with time and the lender will need more funds to cover the rise. Naturally, you will be the one to provide the money. Thus, even if your mortgage is a fixed rate mortgage with what you expect to be quite even payments, the actual amount of money you will have to pay each month can change because of the escrow. If taxes rise, you should expect an unavoidable rise in the payment. And the sooner you find out about it and take action, the better. A long delay in the payment adjustment may cause the escrow account balance to drop too low. If that happens, you will have to face a larger rise of payment than what it would have been had it surfaced earlier. For that matter, the RESPA requires the lender to provide initial and annual escrow account statements. Do make sure you get one. But for the “good to know” feel, it is your proof in any legal procedure should you find out something is wrong with your escrow account. You always need to check with the other party, too - the tax office, the insurance company, etc. - to make sure their bills are paid accurately on your behalf. You may also try to reschedule the issuing of the statement with your loan servicer - depending on the time of year you take out your mortgage loan, the annual escrow analysis date can be changed, so that your payments could be adjusted more efficiently to reflect insurance premium and tax increase more quickly.
• A similar to the described above situation may occur as a result of the lender’s selfish desire to sell you a loan, even if it involves deliberate lies. Sometimes lenders offer an escrow payment that is deliberately lower than the one really required. Relying on the fact that far not all borrowers bother to check with the tax office and insurance companies about the real taxes, or make the calculations described in the tables above, lenders require a wittingly insufficient escrow payment. A sort of teaser amount, that, after a while, grows to the full size plus the compensation for the borrower’s unaware underpayment of the initial few months. That can add up to quite an amount! It’s a kind of scam that is very difficult to prove. The lender can always say that it was an honest miscalculation, plead an accidental totally unintentional mistake (which do happen sometimes), but require the high payments anyway.

Now that you are aware of the risks involved, I hope, it will be easier for you to make a decision about whether you do or don’t want to trust tax and insurance payments to the lender. It’s kind of hard to be sure in advance about whether it will or will not work with a particular lender, but you can take your time, see how it goes for a year or two, and base your choice on the result of these years. Even if everything goes smoothly and you prefer to keep the escrow with the lender, you should not relax completely - the servicing of your mortgage can be sold to some other agent any time and then you have to resume control to make sure that the new agent does not screw up.

What if you don’t want any escrows to go with your mortgage? You have to buy your way out straight away at closing or any time later. Yes, sad, but true. Freedom will cost you around 1/4 to 3/8 of a point. Escrow service is usually included into a mortgage package, and you either agree to it, or you don’t, but it is hard to find an alternative without an escrow included and good conditions otherwise.

• Discount Points (Points)
• Extra Payments
• Refinancing (Part III)