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Mortgage closing: Why does my lender want so much escrow money?

Peter Miller
The Mortgage Reports contributor

Mortgage closing: How much money do you need for “escrow”?

One of the biggest costs you’ll encounter when closing on a home is the “escrow account.”

You’re probably not too excited about contributing to this fund, especially because you have no idea what it’s for.

While this may feel like an unnecessary charge, escrow is actually just a way to prepay costs associated with owning a home.

Let’s dive in a little deeper.

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In this article:

What is escrow, and why does it cost so much?

  • An escrow account is established by the lender at closing with funds from the home buyer. The lender eventually uses the money to pay costs like property taxes, homeowner’s insurance, flood insurance, and more.
  • The escrow account often must be “front-loaded” at closing, to give the lender a little cushion to make sure the money will always be there when needed.
  • Under federal rules, a lender can collect enough escrow funds to cover your annual bills, plus two monthly payments, plus $50.

Why do lenders require escrows or impounds?

The idea behind an escrow fund is to protect both the borrower and the lender.

Everyone knows that a home can be foreclosed if the mortgage is not paid. However, a home can also be foreclosed for other reasons, such as not paying property taxes.

With an escrow account, the lender has the money in hand to pay such costs on your behalf. It’s a way of guaranteeing that you won’t be late on your property tax payments.

The escrow account can also benefit you. Because once established, the account balance is maintained by regular monthly contributions from you, added to your mortgage payment.

If you didn’t have an escrow account, you would likely need to pay hundreds or thousands of dollars to the county a few times per year. That’s hard to budget for.

Likewise for homeowners insurance. Your insurance agent only requires a payment once per year. It can be a large sum. If you didn’t budget for it, your insurance coverage lapses and you won’t be compensated if your home is damaged or destroyed.

How do escrow accounts work?

Escrow accounts hold money collected in advance. When property taxes or insurance premiums are due, the lender pays those “for you.”

Of course, the lender doesn’t actually come up with the money. They simply make the payment from funds they’ve already collected in the escrow account.

Let’s say that your property requires the following annual payments.

  • Taxes: $4,000 per year
  • Homeowners insurance: $1,200 per year
  • Total: $5,200
  • Monthly amount collected by the lender: $433

To maintain the escrow account, the lender will collect 1/12 of the annual bill each month. So if your principal and interest payment on the mortgage is $1,500, your total mortgage payment to the lender would be $1,933 per month.

How much can lenders keep in escrow accounts?

Under federal rules, a lender can collect enough escrow funds to cover your annual bills, plus two monthly payments, plus $50.

In the example above, the lender could have in escrow as much as $5,200 (the expected size of the bills), plus $887 (an amount equal to two monthly escrow payments), and $50. This is a total of $6,137.

Annual reconciliation of the escrow account

Once a year, the lender provides an escrow account statement to you. It must also refund excess money collected.

If the escrow balance is insufficient to cover your costs (perhaps your taxes or insurance premiums have increased), the lender can require you to make up any shortage.

Usually, you get to choose between paying a lump sum, or making up the shortage during the next year by paying a higher monthly escrow fee.

Mortgage closing and escrow

If you buy a home with 20 percent or more down, the lender may waive the requirement to have an escrow account. The lender might require you to put your loan on an auto pay or impose a fee (typically 0.25 percent of the loan amount) to waive escrow.

This means you’d pay your own property taxes, homeowners insurance, and other fees as they become due.

So a borrower with a big down payment can avoid monthly escrow payments. However, the obligation to pay taxes and insurance remains.

Many borrowers who make big down payments still want an escrow account, because it’s an easy way to budget costs and assure that basic bills are paid. Plus, the lender doesn’t charge a monthly fee or “skim off the top” to make the payments for you. One hundred percent of the money you pay into the escrow account must go toward your taxes, insurance, or other fees you would pay anyway.

Risking foreclosure and other problems

What happens if you don’t have an escrow account and fail to pay taxes or homeowners insurance?

In the case of taxes, you can face foreclosure. The county could take your property from you. If you don’t pay for property insurance, the lender will probably purchase a replacement policy for its own protection.

Force-placed insurance can be very expensive, in some cases two-to-ten times the cost of typical policies.

This coverage is called  “force-placed insurance,” and it’s not a good thing. Because the lender is picking the replacement insurance, it does not have an obligation to select the cheapest or best coverage.

Force-placed insurance can be very expensive, in some cases two-to-ten times the cost of typical policies.

How can you avoid force-placed insurance? Get an escrow account.

How do I apply to buy a home?

An escrow account is nothing to be afraid of. The initial cost looks daunting, but you are just paying costs ahead of time.

That said, you want to keep overall upfront costs low. The best way to do that is to shop around for top lenders.

Shop today's top lenders for better rates and lower fees. (Jul 15th, 2019)