Mortgage Minutes defines and describes escrow.
What is Escrow and how does it work? Escrow can be defined as a contractual arrangement in which a third party receives and disburses money or property for the primary transacting parties. The disbursement from escrow is dependent on conditions agreed to by the transacting parties. For the purpose of this discussion regarding mortgage, escrow is a trust account held in the borrower’s name to pay obligations such as property taxes and insurance premiums on behalf of the borrower.
Federal law allows the mortgage lender to require enough money in the escrow account to cover one full year of the bills (insurance, taxes) plus two months extra cushion. In Texas, Mortgage lenders are not required to pay interest to the borrower on escrow accounts.
When you buy a home, the seller is required to pay the pro-rated taxes to date. For example, if you loan is closing August 31, then the seller would pay 8 months of taxes into the buyer’s escrow account (Jan-Aug), and the buyer would be accountable in the escrow account and the buyer would pay the remainder of the year (Sept-Dec). The escrow account is reviewed and balanced at least once per year to ensure that there is enough money (but not more than allowed) to cover the anticipated tax bills.
It is important to note that when a seller has tax exemptions on a property (such as the over 65 exemption, disability/veteran’s exemptions, etc. that the new buyer will not have on the property, the seller is only accountable to pay the pro-rated portion of the taxes based on the seller’s tax bill, and the buyer could have to pay a higher amount due to the potential loss of those exemptions. Note that the buyer should always follow up to file for the homestead exemption if the home is to be the buyer’s primary residence to get the homestead exemption.
The pro’s of escrow include 1) never having any surprise tax bills or insurance bills to pay, since the mortgage company will ensure these bills are paid from your escrow account each year, 2) allows the borrower to pay monthly for a bill that is due annually, which helps with cash flow budgeting, and 3) provides borrowers the ability to pay any shortfalls due to increased taxes over the following 12 months. The con of escrow is that the borrower is paying monthly for a bill that is generally due at the end of the year, and losing the opportunity to earn investment income and/or interest on those funds.
If you don’t want to escrow, most lenders will charge a higher interest rate or fee (generally 0.25%) to waive escrow and generally require higher down payments (usually 20%). Note that some loans, such as FHA will not allow the borrower to waive escrow. At the end of the day, the decision to escrow or not escrow is a personal decision, based on many factors, including loan type, fees, interest rate premiums, budgeting skills, and market interest rates.
Brian Bazar, Sr. Mortgage Banker
402 E Trunk Street, Suite G1, Crandall, Tx 75114