When home buyers opt to "escrow taxes" with a lender, there's a dollar-cost to starting that escrow account. It can add significant costs to a final HUD-1 Settlement Statement, depending on the time of year.

Defining "Escrow Your Taxes"

First, let's answer the question "What does it mean to pay taxes in escrow?"

Paying taxes in escrow is a two-sided agreement between homeowner and lender:

1. Homeowner pays 1/12 of his annual real estate tax bill to the lender each month
2. Lender holds the homeowner's payments in a reserve account, and pays the home's real estate taxes when they come due

Most lenders wants homeowners to escrow because it ensures the taxes actually get paid. As such, lenders penalize people that opt to pay their own taxes, without bank help.  The penalty is a fee and it's known as "waiving escrows".

The fee to waive escrows can be as high as 0.25 percent of your loan size, or $250 per $100,000 borrowed.

Starting Your Tax Escrow Can Be Costly

Meanwhile, seeding an escrow account can be costly, depending on the season, with the schedule dictated by the local taxing authority.  In Southeastern Ohio, we're entering the Expensive Season.

Because semi-annual tax bills due in June and July, lenders want to make sure there's enough money on-hand to pay the pending bills.  In Hamilton, Warren, Butler and Clermont counties, up to 8 months of tax reserves are required for mortgages closing in the months of May and June, and November and December.

The reserves are broken up into two parts:

1. 6 months worth to pay the semi-annual tax bill
2. 2 months worth of reserves in case tax bills increase unexpectedly

My experience is that most homeowners understand the "one-twelveth" part of paying escrows each month, as well as the reason why seeding an escrow accounts gets more costly as bills come closer to their due date.

It's the "extra 2 months of reserves" that throws folks for a curve.  Here's the explanation.

Lenders Want Your Tax Bill, Plus Some Extra

Real estate taxes tend to increase over time.  Homeowners know it, and lenders know it, too.  It's inevitable.  Therefore, instead of running the risk of holding too little tax money, lenders aim to hold too much.

This way, if-and-when tax bills rise, lenders are using your "excess" instead of their own.  And so long as taxes increase by less than 16.67% annually, the banks should never be short on your funds.

When you're planning for your closing, don't forget to budget for escrow reserves.  If you want help with your math, call or . I'll do my best to walk you through it.

Editor's Note: The chart above does not apply to refinances. Refinances in the Cincinnati area have a slightly different escrow reserve chart. The theory is the same, the withholding is different.