Buying a home is a significant investment for home buyers, and an escrow account protects that investment for both the borrower and their lender.
An escrow account simplifies the mortgage payment process for the buyer and decreases the likelihood that the borrower will fall behind on payments. As a result, the lender carries less risk on the loan, and both parties reap the benefits.
How do escrow accounts work?
When you make your mortgage payment, the funds are applied to four different sources:
- Principal – reduces the amount owed on the loan balance
- Interest – covers the cost of borrowing that money – this portion is paid to the lender
- Taxes – applied to county or city property taxes
- Insurance – covers any insurance premiums that protect your home (i.e. homeowner’s insurance, flood insurance, wind/hail insurance) or PMI (private mortgage insurance)
A portion of your monthly mortgage payment goes into your escrow account to cover any property taxes, property taxes, or PMI (private mortgage insurance). Then, the remaining funds are applied to your principal balance and interest.
When is an escrow account required?
On government-backed loans, such as VA, FHA, or USDA loans, you need to have an escrow account for insurance and taxes (regardless of your down payment amount). On conventional loans, you need an escrow account for PMI if your down payment is less than 20%.
Why do lenders need escrow accounts?
When lenders are collecting, holding, and disbursing the funds for taxes and insurance, there is less risk of nonpayment.
For example, nonpayment of insurance could occur if a home were to burn down or suffer some other type of damage without coverage. Then, most of the loan’s collateral is gone.
Nonpayment of property taxes could cause a tax lien to pop up on the property. Even worse, the city or county could foreclose as a result of the nonpayment of property taxes.
Escrow accounts prevent the risk of nonpayment and protect a mortgage lender’s investment (and yours too).
Note that if a property has HOA dues, you won’t use an escrow account to pay them. Even though HOA dues are a housing expense, you pay them directly to the homeowners association.
Escrow account setup when buying a home
If you are a buyer that wants or needs to set up an escrow account, you will need to add your first payments into it at closing. So, how much should you figure?
A good rule of thumb would be the following:
- One year of insurance(s) upfront for the policies you need or want
- Two months of insurance payments
- Six months of property taxes
Lenders generally require a two-month cushion for any monthly amounts in an escrow account. This helps cover any probable increases due the following year.
Using an escrow waiver to pay your taxes and insurance
As mentioned before, conventional loans with 20% equity or more allow a borrower to waive escrow accounts. In other words, you will be responsible for your property taxes and insurance. Remember, lenders prefer you to use an escrow (less risk). So to waive an escrow account, they will often charge a fee or an increased rate. Typically, the charge is .25% of the loan amount. Thus, a $100,000 loan would have a $250 escrow waiver fee. So even if an escrow account isn’t required, it can be advantageous.
The bottom line
Escrow accounts help mortgage lenders protect their investments by ensuring that property-related insurance premiums and property taxes get paid on time. As a result, the home’s policies stay current and there aren’t any issues with tax liens. While an escrow account can be beneficial whether you need it or not, you will need to plan on one if you’re getting a government-backed loan or if you’re putting down less than 20%.
As always, the team at OVM is here to answer any questions you have and help guide you through the mortgage process. Give us a call or if you’d like to take the first step toward getting a home loan, you can start your application today at ovmfinancial.com/QuickStart.
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