When securing a home loan, new borrowers may overlook escrow accounts, which are used in part to protect the lender. Under escrow, monthly payments are collected to pay annual insurance and taxes. While some mortgages -- most notably FHA loans -- require the establishment of an escrow account, the decision is typically up to the lender. As a borrower, you should take into account certain factors when planning for your escrow.
Establishing a Cushion
Escrow accounts are typically used to cover your annual property taxes, as well as the yearly cost of homeowners insurance. Each month, you will be responsible for one-twelfth of those two totals. As of 2013, the Real Estate Settlement Protection Act allows lending institutions to maintain a monetary cushion equal to one-sixth of the annual escrow collection. This means that, upon loan approval, you may be required to immediately pay two months worth of payments into your escrow account.
The taxable value of a property is often reassessed the year after a home is built on the land or the year following a sale of an existing home. This means that your tax rate could increase -- in the case of new construction, it may rise drastically -- a year after you move in to your new home. If taxes rise, your escrow payment will increase accordingly. And if the tax shift doesn't match up with your annual escrow calendar, you could get an unpleasant surprise. For instance, say your July tax bill indicates that you owe $6,000 more in taxes than you owed the year before. Since January, though, you have paid six payments into your escrow account, assuming your old tax rate. Not only will your typical escrow payment increase by $500, but you must also make up the $3,000 difference for the first six months of the year.
Similarly, your homeowners insurance rates may fluctuate greatly from year to year and hikes could result in an increased escrow payment. It is important to understand that the bank typically has nothing to do with your insurance; it simply organizes the payment. Therefore, if your insurance company informs you that your rates will be changing, it is up to you to figure out what effect it may have. The bank will only send you a monthly escrow bill and is under no obligation to warn you that your insurance rates have increased.
Your source of income plays a significant role in whether you will be able to handle an escrow account. If your monthly income fluctuates drastically, you may have trouble paying the escrow payment one month, but could have more than enough the next. If you are in this situation, it may be better for you to simply save at your own pace over the course of the year. You will still need the same amount of money saved up to pay insurance and tax bills, but you won't be faced with a set monthly payment.