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Escrow makes payments -- even on fixed-rate mortgages -- variable

Think of it as insurance for the insurance.

Mortgage escrow accounts exist to help borrowers accumulate money for property taxes and homeowners' policy premiums a little at a time. Escrow can help avoid financial surprises such as missed payments to the government, but foul-ups can happen and borrowers need to keep a close eye on what money is going where.

Not everybody needs to set them up, but home buyers may benefit from using them. "The lender is going to pay your taxes for you, and many first-time homeowners, that's the way they prefer it," says Rick Harper, director of housing for the Consumer Credit Counseling Service of San Francisco. "They don't want to get stuck with a huge tax bill."

When people take out long-term, fixed-rate loans, they may not realize the amount they pay will sometimes fluctuate from year to year. The culprit that unfixes the fixed loan is the escrow account. Some people are required to have them -- chiefly borrowers who put less than 20 percent down and people with government-insured mortgages such as those backed by the Federal Housing Administration or Department of Veterans Affairs.

How escrow operates
Escrow operates somewhat like a savings account, but customers must make monthly deposits as spelled out in their loan documents. Those payments accrue at the bank -- with interest in some states -- and the lender becomes responsible for paying the borrower's property taxes and insurance premiums. An escrow account usually remains in place until a borrower pays the mortgage down to the 80 percent loan-to-value threshold, though people can elect to keep the account in place for the full loan term.

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"The escrow account can be a wonderful tool for people to be able to effectively budget. Those bills are being paid and they're obligated to be paid no matter what," says Jan Schamp, escrow manager for the Norwest Mortgage arm of San Francisco-based Wells Fargo & Co. "We have a lot of people who choose to leave that escrow intact."

Going into a loan, it's difficult to know exactly how much escrow payments for "TI" -- taxes and insurance -- will increase the overall monthly bill for "PITI," or principal, interest, taxes and insurance, lenders say. The seller will often volunteer to show the most recent tax bill, or borrowers can get the information through the local tax-collection authority, usually an arm of the county government.

"They can check locally to know what's reasonable," Schamp says.

As taxes and insurance policy bills change, so will escrow payments.

Recalculated each year
Most lenders run an analysis program each year to see whether the amount a borrower contributed over the course of the past 12 months was enough to cover all the tax and insurance bills due during that period. Customers receive a transcript of the results showing what was paid out and what was collected.

Lenders typically require that an extra month or two of payments be maintained in the account as a reserve. But because tax assessment or rate changes and premium adjustments can happen any time over the course of 12 months -- and escrow payments remain constant for a year at a time no matter what -- lenders sometimes have to cover shortfalls out of their own pocket. They recoup that money the following year by boosting a person's required monthly deposit.

"After the end of the first year, the regular escrow analysis done by lenders will compare what we initially told them would happen to what actually happened," says Schamp. "We projected this much money would go in and this much money would go out. This is what actually came into the account and this is what actually went out."

While these annual adjustments cause a mild stir in a homeowner's budget, escrow can occasionally shift dramatically.

Payment adjustments
With new construction, escrow payments tend to surge after a property's completion, according to Sandra Munn-Travis, vice president of mortgage loan servicing for Harris Bank. The Chicago-based company is a subsidiary of Bank of Montreal.

"What the customer needs to watch out for is the fact (lenders) are required to calculate escrow based on the last disbursement," she says. "If the house is being built from scratch, the (last tax) bill is only going to be on land. There may be charges of just $800 on that land, so their escrow is going to be very small.

"The next year, depending on when the house is totally built, they may get one payment that's just land, but the second payment is improved with the house on it. All of a sudden the taxes go sky-high and there's such a shortage" in the escrow account, she adds. The lender will cover that shortage, but it will have to do things to compensate: increase the base escrow payment the following year to cover the higher taxes and make up the loss by dividing it into 12 portions and adding it to each of that following year's monthly payments.

Watch closely when loans change hands
Borrowers also should watch their escrow accounts closely when any loan transfer occurs. A transfer can happen in one of two ways: when somebody refinances or when a lender sells its loans to another company.

Legally, the old lender must pay taxes and insurance up until the loan either closes or leaves its possession. But with so much paperwork involved, wires do cross. Sometimes, both companies end up paying the tax bill -- and sometimes neither one does. In either case, a homeowner's bill can be affected the next time escrow is adjusted. As long as the homeowner has made the proper payments, the lender is responsible for any problems created by an unpaid bill, but straightening it out can take time. Lenders say the best way to avoid problems is to communicate and make sure all the parties involved know the game plan. Customers should also keep all records and review them for errors.

"The customer has to be the proactive one," says Howard Gosnell, escrow services manager for Mercantile Bancorporation Inc.'s mortgage division. The bank is based in St. Louis.

In the event of a loan sale, for example, the escrow account typically will transfer to the new lender along with the mortgage, according to Norwest's Schamp. A borrower should receive a statement from the old lender spelling out everything that was collected for and paid out by the escrow account up until the day of transfer. He can compare that with the annual escrow analysis statement sent by the new lender at the end of the year. It should pick up where the old one ended.

With a refinance, the old lender usually shuts the escrow account and either reduces the amount it gets at closing by the balance of the account or refunds the borrower via check. The company should provide a short-year analysis of activity in the account up to that point in either case.

Still, a customer can do everything by the book and run into trouble. That's because large mortgage companies usually process borrower payments in huge computerized batches.

A nationwide player, for example, may already have sent an individual's money along to a third-party tax processor or the taxing agency itself ahead of the actual tax due date. If a borrower closes his loan out with the old lender -- and the new lender pays the bill on its actual due date with the new escrow account -- he may end up waiting months to get a refund from the old lender. Some tax authorities may refuse a refund altogether and consider one of those payments a prepayment toward the following period's bill.

"The borrower anticipates he's going to get the money back from us but that money may already have been sent to the tax company," Gosnell says. "Or there are even cases where the taxes may already have been paid.

"It causes real problems, especially in situations where you have a refi boom like 1998 when a lot of those refis occur within the same time frame."

People should therefore not count on using an escrow tax rebate to cover the new loan's closing costs.

-- Updated: Oct. 23, 2002
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