When it comes to home ownership, most have at least some type of homeowners insurance and must pay property taxes. Mortgage companies particularly care about borrowers paying their taxes and insurance(s). So much that mortgage lenders and many home loans require an escrow account. Basically, an escrow account is where funds are regularly deposited, held, and then disbursed for property taxes, any required property insurance, and potentially PMI. I like to say that clients should think of having a savings account (where you don’t get paid interest) where 1/12 of the tax and insurance amounts are deposited into this account monthly.
Then once per year, the annual insurance premium and property taxes due (depending on the state, may be quarterly, semiannual, or annually) are withdrawn as needed. Even though lenders prefer that borrowers establish an escrow account, there is a case where escrows may be waived. We explain this along with the mortgage requirements for escrows below.
When is an Escrow Account Required?
The quick answer is most of the time escrows are required. Basically, an escrow account is required on any conventional loan with less than 20% down payment or equity. Although, government loans such as USDA, VA, and FHA, require an escrow account for taxes and insurance. Actually no matter how much down payment is made on a government loan, escrows are required. Just like FHA requires mortgage insurance even if a borrower puts down over 20% down payment.
Why do lenders want borrowers to escrow? Everything about mortgage lending is based on risk. Lenders feel if they are collecting, holding, and disbursing the funds, there is less risk of nonpayment. Nonpayment of insurance means the house could burn down without coverage. Then most of the loan’s collateral is gone. Nonpayment of property taxes means a tax lien could pop up on the property. Even worse, the city or county could foreclose as a result of nonpayment of property taxes.
What is Included in an Escrow Account?
Foremost, mortgage payments always require a principal and interest payment or at least an interest only payment. This part pays back the money plus any interest due. These must be done or the result is a foreclosure. Over and above the basic payment, often comes paying for taxes, insurance, and PMI. These are included in the escrow account.
- County property taxes
- City property taxes
- Homeowners insurance (also called hazard insurance)
- Flood insurance
- Wind & hail insurance
- Mortgage insurance (PMI)
If a property has HOA dues, they are not included in an escrow account. Even though HOA dues are a housing expense, they are paid directly to the Home Owners Association.
Escrow Account Setup When Buying a Home
A very popular question when purchasing a home is “What are the closing costs?”. Closing costs include the appraisal, attorney or settlement agent, title insurance, credit report, lender fees, and such. But, when a buyer is required to or chooses to have an escrow account, those funds are also collected at closing. So, how much should you figure?
A good rule of thumb to come close on a purchase would be the following:
- 1 year of insurance(s) is collected to put the policy(ies) in place
- 2 months of insurance
- 6 months of property taxes
A common borrower question is “why do I need to put 2 months of insurance into escrows when I have paid one year up-front?”. It is a good question. But, lenders generally require a 2 month cushion of any monthly amounts in an escrow account. This helps cover probable increases due the following year.
Using an Escrow Waiver to Pay Your Own Taxes and Insurance
As mentioned before, conventional loans with 20% equity allow a borrower to waive escrows. In other words pay your own property taxes and insurance. Remember, lenders prefer you to escrow. So to waive an escrow account, lenders will charge a fee or an increased rate for this. Typically, the charge is .25% of the loan amount. Thus a $100,000 loan would have a $250 escrow waiver fee.
Not Everyone Has to Pay Taxes and Insurance!
Wait, doesn’t everyone have to pay property taxes and insurance? Actually, no. You may have noticed in the beginning of this article where it says most pay taxes and insurance. First let’s talk about insurance. If there is a mortgage on the property, any required insurances must insure the property. But when a property is free and clear of any mortgages, the homeowner is not required to have insurance on the home. Even though it is highly recommended to cover a dwelling with insurance, free and clear homes do not require it. Even the government or anyone else will not require it.
Reasons for No Insurance
Regretfully, some homeowners cannot afford to pay homeowners, wind & hail, or flood insurance. So, they cancel it and hope that there is never any damage. Other homes may be in such bad condition and maybe not occupied, that insurance doesn’t make sense. Maybe the home is not even insurable too. But keep in mind, insurance is required when a mortgage is secured by a home
How to Pay No Property Taxes or Reduced Property Taxes
Most property owners are required to pay property taxes. This includes county and city (if within the city limits) property taxes. But, some homeowners may qualify for property tax discounts or even a property tax exemption. In order to receive these property tax benefits, homeowners must meet certain qualifications. Here are some scenarios which may reduce or get rid of property taxes…
- 100% military service connected disability
- Senior citizen
- Low income
If a homeowner has one or more of the above traits, he/she should check with their county tax office. Also, learn more by checking out some of our articles that explain this further.