Q & A: Why Do I Have To Set Aside Four Months In Escrow? I Just Paid My Taxes!

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I am remortgaging a home for a client and we decided that it may be better for her to escrow her real estate tax payment with the lender. 

This is a new arrangement for her; she currently pays her tax bill from her bank account.

In reviewing the new loan's numbers, she noticed that we were setting four months worth of taxes aside to populate her new escrow account. 

Her first installment of Cook County taxes are due March 1 and her question followed:

How did the lender decide how much money I have to set aside for taxes?  Why do I need to bring four months for taxes if I just paid them?

I can't speak definitively for other locales, but in Cook and the Collar Counties, taxes are paid semi-annually.  The two dates of payment vary by county, but either way, the real estate tax liability is split into two parts.

In Cook County, for example, tax bills are due March 1 and September 1.

To take a step back, we should briefly address: "What does it mean to pay taxes in escrow?" 

Paying your taxes in escrow means that your lender agrees to handle your real estate tax payments for you, and that you agree to set aside money each month with your lender so your lender has the funds to make those payments.

Each month, a mortgage payment for escrowing homeowners is comprised of the actual mortgage payment plus an additional payment of 1/12 of the year's tax bill into an escrow/reserve account.

Because funds are already on deposit, when the tax bill comes due, the lender makes the payment on behalf of the homeowner from its reserve account.

Okay, now we know how escrow works.  Let's get back to the question.  If the tax bill was just paid, why does the lender need four months of reserves on hold. 

As my client was asking, wouldn't collecting four that mean that six months from now, the lender will have way too much money in the escrow account?  Like, 10 months?

The answer is "sort of".  And for the lender, it works out like that absolutely on purpose.

See, real estate tax bills tend to increase over time and the lender is usually the last to find out that a tax bill went up.  This is because when a homeowner's tax bill increases, the taxing body will send a letter to the home and not to the lender.  Rarely does the homeowner notify the lender about it.

Lenders know this.  And, they also know that they never want to be caught short-handed when it's time to pay a client's real estate tax bill.  They'll pay the bill either way because they are contractually obligated to do so, but they'd much rather do it with your money than with their's.

To make sure that it's your money paying your bill as often as possible, lenders will usually ask that you maintain two more months in reserve than are technically necessary to pay the tax bill. 

That way, so long as the taxes don't increase by more than 16.67% annually, the lender will never have to go out-of-pocket to cover your homeowner's liability. 

That brings our "10 month reserve" down to eight months.  Now, let's tackle how we go from eight to six.

My client is closing her loan in mid-March which means that her first mortgage payment will not be payable to the lender until May 1. 

At her closing, she will pay mortgage interest for March, but no principal and no tax proration.  In addition, she will not make a mortgage payment at all in April.  Therefore, there is no 1/12 tax payment being made in March or in April.  These two months are the make up the difference between eight and six!

So, even though my client just paid her March 1 tax bill this week, she will need to populate her escrow account at closing with four months of reserves to make the lender happy:

• 1 month for the "missing" March payment
• 1 month for the "skipped" April payment
• 2 months for the escrow "cushion"

By the time she starts paying her mortgage in May, she will be right on track to have eight months in the escrow account come September 1 -- just like the lender wants.