If you are about to place an offer on your first home there are many real estate and mortgage terms that you have been exposed to in the past few weeks. The world of real estate seems to have its own language at times and your loan officer will be talking in his own terminology through some of the upcoming process.
One important term to know and something you will be entering into once you sign on the dotted line is “escrow”.
What is Escrow?
When you close on your mortgage your lender typically requires you to have an escrow account that will cover the year’s property taxes and homeowner’s insurance for your new home. At closing you make an initial deposit and then payments to the account every month, which is typically added into your monthly mortgage payment.
When you put money in escrow it is held by a neutral third party (called an escrow agent) who works for both the lender and the borrower. The agent’s role is to carry out the instructions agreed upon by the contract. In other words, the escrow agent releases the funds as your taxes and insurance premiums come due.
Why is this Required?
Escrow funds are collected to protect the lender by ensuring that you pay your taxes and insurance on time. If left to the homeowner, separate from the mortgage, it is possible for these expenses to go into default, which threatens the lender’s investment. If you default on your property tax, for example, your municipality can put a lien on the house, which makes it hard to sell. If you did not pay for the insurance and your house burns down, the lender would be left with no collateral.
Does escrow help me in any way?
Escrow helps homeowners budget because spreads insurance and tax expenses evenly over 12 payments. For example, if your annual property taxes are two payments of $3,000 and your homeowners insurance is $400 annually you would have to be saving money towards these expenses each month or be faces with a large bill when they are due. Many homeowners find budgeting one of their greatest challenges, but the escrow costs, factored into your monthly mortgage make it a manageable $533 a month. It basically makes you plan and pay as you go so there is no large bill to pay in one lump sum.
Will there be enough to cover the bill?
Your escrow account is collected in a way that includes a built-in cushion, so if you miss a payment, the lender must still be able to pay your accounts on time and if your insurance rate goes up slightly, the bill can still be paid in full. Federal law prohibits lenders from requiring more than two months of expenses in escrow and because your tax and insurance costs will change slightly from year to year, the lender will review and adjust your escrow payments annually to maintain the cushion.
Understanding the terms of your agreement and how much of a cushion will be kept in your escrow account are questions you should ask before you close on the mortgage. In general, money held in escrow insures you and your lender have two less budget items worry about.