Mortgage escrow account pros and cons

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An escrow account is part of the financial picture for most homebuyers who are purchasing a property with a mortgage.

This special holding account is used to pay their annual property tax bill and homeowners’ insurance premiums. However, instead of scheduling payments and paying these bills separately with a checking account (as one typically does with a utility bill), the money is collected by the lender through installments as part of the homeowner’s regular monthly mortgage payment. The lender then uses the money in the escrow amount to pay the tax and homeowner’s insurance bills as they are due.

Some homeowners are required by their lenders to have an escrow account; others may opt-in to having an escrow account with their mortgage servicer.

What is escrow?

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 defined as a legal arrangement with a neutral third party, where money is deposited per the terms of a contract. When it comes to your mortgage, your loan servicer acts as the neutral third party.

What are the pros of an escrow account?

It’s automatic. Holding your property tax and homeowners insurance payments in escrow ensures that those bills are paid on time to avoid penalties, such as late fees or potential liens against your home.

You’re covered when there are shortfalls. Your insurance premiums and property tax assessments will fluctuate over time. If your escrow account happens to be short due to your tax bill increasing, for example, the servicer will typically cover the difference temporarily. (The servicer will eventually increase your monthly mortgage payment to make up the difference).

No surprises. The exact amount needed for escrow payments is added to your monthly mortgage payment for you. You’ll get a notice from your lender in writing when they need to increase the escrow component of your monthly mortgage payment. Plus, your 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 (homeowners) insurance and property tax bills,” says Greg McBride, CFA, Bankrate’s chief financial analyst.

Potentially lower mortgage costs. Depending on your lender, you may 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.

This pro can be a con for savers who can put their escrow money to better use. The mortgage servicer is allowed to collect the amount of your payments, plus a cushion amount, month in and month out.

You might miss out on short-term investment opportunities.

The money that could end up as overages in an escrow account could be used for short-term investments. Earning interest on such investments makes more financial sense to many people instead of allowing a bank or lender to reap the gains.

Creating an escrow account is a personal decision, though, and some homebuyers might prefer to have more of their liquid cash work for them outside of an escrow account, says Henry Yoshida, CFP, CEO of Rocket Dollar, a self-directed IRA and solo 401(k) provider based in Austin, Texas. Digital tools and attractive CD rates can help you invest your money outside of escrow and earn a better return for the long term, he adds.

Examine the current interest rates and your budget to determine whether it makes sense for you.

“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 homeowner to deposit an amount equal to several months of property taxes.

An escrow account can be tough to get rid of.

Once you have an escrow account with your lender, it’s difficult to remove later if you change your mind.

Escrow accounts can be targets for scammers.

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

Can I avoid an escrow account?

Deciding whether to set up an escrow account with your lender or pay your property taxes and homeowners insurance on your own depends on your personal situation and financial habits.

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

When do I need an escrow account?

An escrow account is likely not optional if you’ve put a downpayment of less than 20 percent on your home. This is particularly true if you’re getting a loan insured by the Federal Housing Administration (FHA). FHA loans require escrow accounts.

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