Mortgage escrow account pros and cons

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A mortgage escrow account is part of the financial picture for most homebuyers. Some homebuyers are required by their mortgage lender to have an escrow account; others may opt-in to one through their mortgage servicer.

What is a mortgage escrow account?

A mortgage escrow account is an account used to pay a homeowner’s property taxes and homeowners insurance premiums, and at other times to hold an earnest money deposit when the homeowner first purchases their home.

Instead of scheduling payments and paying insurance and tax bills separately with a checking account, the money for these payments is collected by the mortgage lender or servicer through installments as part of the homeowner’s mortgage payment. The lender or servicer holds these funds in an escrow account and pays these bills as they are due on the homeowner’s behalf.

The key difference between an escrow account and any other financial account you may have is that you don’t manage this one yourself. That’s because “escrow” is facilitated by a neutral third party — in this case, your mortgage lender or servicer.

An escrow account is likely not optional if you’ve put a down payment of less than 20 percent on your home. FHA loans and USDA loans require escrow accounts, but VA loans do not.

What are the pros of an escrow account?

It’s automatic

Having your mortgage lender or servicer hold your property tax and homeowners insurance payments in escrow ensures that those bills are paid on time, automatically, so you avoid penalties such as late fees or potential liens against your home.

You’re covered when there are shortfalls

Your homeowners insurance premiums and property tax assessments can fluctuate over time. If your escrow account happens to be short due to your property tax bill increasing, for example, your servicer will typically cover the difference temporarily, and eventually increase your monthly mortgage payment to make it up.

No surprises 

The exact amount needed for escrow is added to your monthly mortgage payment for you, so you’ll know what to expect the majority of the time. If the escrow component of your monthly mortgage payment needs to increase, you’ll get a notice from your lender or servicer in writing. Plus, your lender or servicer is required to send you an annual escrow statement that shows the amounts you’ve paid (and the drawdowns) along with any overages or shortages.

“Escrow accounts make life a lot easier for the majority of homeowners that want to add predictability to their monthly expenses, rather than getting whacked twice a year with big insurance and property tax bills,” says Greg McBride, CFA, Bankrate’s chief financial analyst.

Potentially lower mortgage costs

Depending on your mortgage lender, you may be able to get a discount on your interest rate or closing costs just by having an escrow account.

What are the cons of an escrow account?

It’s automatic

Your mortgage lender or servicer is allowed to collect the amount of your homeowners insurance and property tax payments, plus a cushion, month in and month out, in escrow. While it’s nice to not have to think about making these payments, this pro can be a con for savers who may be able to put the funds to better use.

You might miss out on short-term investment opportunities

Likewise, the money that could end up as an overage in an escrow account could be used for short-term investments. Earning interest on such investments may make more financial sense for you, instead of allowing a bank or lender to reap the gains.

Digital tools and attractive CD rates can help you invest your money outside of escrow and earn a better return for the long term, notes Henry Yoshida, CFP, founder and CEO of Rocket Dollar, a self-directed IRA and solo 401(k) provider based in Austin, Texas.

If you’re considering this route, it’s best to examine current interest rates and your budget.

“With interest rates where they are, there is limited opportunity cost from forgoing interest earnings on money that is instead being escrowed by the loan servicer throughout the year,” McBride says.

A potentially large upfront payment 

Often, setting up an escrow account requires a homebuyer to deposit an amount equal to several months of property taxes and insurance premiums. These are sometimes called “prepaids,” and can significantly add to your mortgage closing costs.

Can be tough to get rid of

Once you have an escrow account with your lender or servicer, it can be difficult to remove later if you change your mind.

Can be targets for scammers

The large sums parked in an escrow account make them attractive targets for fraudsters. Cyber thieves often set up fake websites that look similar to the servicer you’re working with, or spoof email addresses to try to get your personal information. Some sophisticated scammers even set up fake phone lines in an attempt to build up trust.

Bottom line

Maintaining a mortgage escrow account may or may not be required, depending on the specifics of your loan. Many mortgage lenders allow homeowners to make property tax payments directly to the county assessor and homeowners insurance premium payments to their insurer, but in order to have this option, they generally require a loan-to-value ratio below 80 percent. That means you’ve made a down payment of at least 20 percent on your home.

Ultimately, an escrow account is a common financial tool mortgage lenders and servicers use, helping to ensure your obligations as a homeowner are met without much effort on your part (aside from making your mortgage payment). However, if escrow isn’t required, you may want to explore alternative uses for those funds.

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