If the prospect of paying a large property tax bill twice a year is daunting, consider the up and downsides of having an escrow account, also known as a mortgage impound account.
Did you think that when you stopped renting and started owning, you’d finally get your deposit back for good? Think again. If you decide to buy a house with a down payment of less than 20%, your lender may require you to make a deposit on your homeowners insurance, private mortgage insurance, any required additional insurance (like flood insurance) and your property taxes.
Since low down payment borrowers are considered to be a higher risk due to their lower personal stake in the property, lenders want some level of assurance that the state will not seize the property because of non-payment of property taxes, and that borrowers won’t be without homeowners insurance in the event that the property is damaged. An impound account ensures that the only person who will become owner of the house in case of default will be the lender.
An escrow account, also called a mortgage impound account, is an account the lender uses to pay the borrower’s non-mortgage related property ownership expenses. The big expense covered by escrow accounts is property taxes, but they can also be used to pay homeowner’s insurance and homeowner’s association dues. At close of escrow, the borrower usually prepays a couple of months’ worth of taxes and insurance into the mortgage impound account; thereafter, the taxes, insurance and other costs are rolled into the mortgage payment and the lender breaks the single payment up and directs it to the appropriate payee.
There are a number of implications that arise when an escrow account is put in place for a loan:
- Sticker shock prevention. Property taxes are collected by most counties twice per year. With an escrow account, the lender collects a prorated amount toward the annual tax and insurance bills every month, preventing borrowers from getting socked with a big lump sum tax bill that is harder to pay.
- Convenience. Homeowners who have their taxes, insurance and even HOA dues collected via escrow account make a single payment monthly that covers all these bills, rather than having to write multiple checks on different schedules to the mortgage company, tax assessor, insurance company and HOA. This minimizes the discipline and organization required to pay all these items consistently on time.
- Lost interest. Most escrow accounts do not bear interest, though some states do require escrow accounts to pay at least a small interest rate. Some consumer advocates bemoan the loss of potential interest homeowners could be earning on their tax and insurance monies. Owners with sufficient equity in their homes to opt out of having an escrow account can replicate the convenience of an impound account, without the disadvantage of lost interest, by having the monthly allotment of tax and insurance funds automatically directed to an interest-bearing savings account until it is time for the bi-annual tax and insurance payments.
- Fluctuations in monthly payment. Usually, lenders adjust escrow accounts and, thus, their borrowers’ escrow payments, on an annual basis. Property taxes, assessments and insurance premiums change annually, so escrow accounts need to be tweaked to match. As such, even if you have a 30-year fixed rate mortgage, with an impound account, your monthly mortgage payment may change from year to year. (Realistically, though, without an escrow account, the non-mortgage costs of ownership will still fluctuate — they just would not impact the actual mortgage payment.)
For many homeowners, a mortgage impound account is necessary. Without them, lenders might not be willing to give mortgages to borrowers with low down payments. The best way to deal with a mortgage impound account is to understand how it works, monitor it carefully and get rid of it when you can.