What is an escrow account? How do they work?

If you are looking at obtaining a mortgage or already have one, more than likely you will need to deal with an escrow account.  It can be difficult to understand the timing and moving piece within the escrow account.  Inevitably, if you have an escrow account your mortgage payment will change each year.  Understanding how escrow accounts work is the key to understanding the why behind your yearly payment adjustments.

What is a escrow account?

Simply put, an escrow account is an account managed by your lender to pay taxes, insurance, and PMI (if required).  Funds are collected monthly as part of your house payment and set aside in the escrow account.  Those funds then build up over time. When the tax and insurance bills come due, the lender then pays those bills with the funds in the escrow account.  For escrow accounts on federally related mortgage loans the government has specific rules lenders must follow.

Is an escrow account required?

Sometimes you can opt to pay your taxes and insurance on your own.  The loan program and down payment will determine if an escrow account is required.  The following table outlines the basic requirements for each program:

Loan Program Escrow Account Options
FHA Required
Rural Development Required
VA Required
Conventional with less than 20% down payment Required
Conventional more than 20% down payment Optional

How does an escrow account work?

There are a couple of different parts that go into an escrow account calculation.  The monthly amount required to be paid into escrow is a very simple calculation.  The annual taxes, insurance, & PMI are added up and divided by 12 months.  That amount gets added to the principle and interest portion of the payment to come up with the total monthly amount due.

Example:  P&I portion of the payment $990 per month.  Annual Taxes $2,400 (1,500 summer + 900 winter)  Annual Insurance $1,000

2,400 + 1,000 = $3,400 / 12 = $283.33 per month

Total Mortgage Payment:  990 (P&I)+ 283.33 (taxes & insurance) = $1,273.33 

Each month as the payment is made the P&I is going towards paying down the balance of the loan and the interest due.  The escrow portion of the loan is set aside in the escrow account to pay the bills as they come due.  Lets elaborate on our example.  Below you can see how each month money goes into escrow and the bills that get paid out from escrow.

Example: 

Month Description Payment Disbursement Balance
Beginning Balance $1,700.00
April $283.33 $1,983.33
May $283.33 $2,266.66
June $283.33 $2,549.99
July $283.33 $2,833.32
Summer Tax Bill $1,500 $1,333.32
August $283.33 $1,616.65
September $283.33 $1,899.98
October $283.33 $2,183.31
Insurance $1,000 $1,183.31
November $283.33 $1,466.64
December $283.33 $1,749.97
Winter Tax Bill $900 $849.97
January $283.33 $1,133.33

What is the yearly reanalysis of the escrow account all about?

Taxes and insurance change every year.  Because of this each year your lender or servicer will reanalyze your escrow account.  Your mortgage payment will be adjusted up or down to account for any differences in taxes and insurance.  Lenders will typically hold a two month cushion calculated on the low point of the escrow account.  This helps off set minor changes in taxes and insurance.

Escrow Overage

An escrow overage is when you have overpaid into the escrow account.  When the lender reanalyzes the account and sees there is more money than needed in escrow, you will receive a check returning some of the funds to you.

Escrow Shortage

An escrow shortage is when you don’t have sufficient funds in the escrow account to cover upcoming tax and insurance bills. If this happens, your lender will send you a love letter increasing your payment to account for the higher taxes and insurance.  The payment increase is to recoup the shortage in the escrow account.

Lets elaborate on the example a little more.

Example:   In our previous example we were using $2,400 for taxes and $1,000 for insurance.  The total payment was 1,273.33.  Lets say that the taxes and insurance went up a bit over the course of the year.  When the lender reanalyzes the escrow they see that the taxes went up to $3,000 a year and insurance to $1,200.  

$4,200 (new taxes and insurance) – $3,400  (prior year) = $800 difference

$800 / 12 = $66.67  – so the house payment will need to be increase $66.67 to account for the higher taxes and insurance. 

If this all transpired this way there would also be a shortage in the escrow account.  There is a shortage because the lender was collecting $3,400 a year but paid out $4,200.  So the escrow account will be short by at least the $800 difference.  At this point you have 2 options;  One would be to send the lender the $800 and have the payment increase by $66.67 per month, or spread the $800 out over the course of the next year.  If the latter option was selected, the payment would increase $133.33 for the next 12 months.  Once the shortage was caught up it would go down by $66.67. 

It would look something like this:

Total payment for 12 months is $1,406.66

After 12 months passes, the total payment would be $1,339.99

Clear as mud????

Escrow accounts can be super confusing.  There are many moving parts and everyone’s scenario is different.  If you don’t live and breath this stuff it’s hard to understand.   No worries, you don’t have to be a mortgage pro to get answers.  That’s what we are here for.  If you have any escrow related questions feel free to reach out,  we are here to help.

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