Mortgage Rates

Escrow Accounts: Protect Your Investment from Bank Error

Buying a house means more than just taking out a mortgage and making monthly principal and interest payments. Many lenders also require borrowers to pay additional monies each year to cover property taxes, homeowners insurance and similar auxiliary expenses. A percentage of the annual cost of these expenses is added to the monthly mortgage payment and held in an escrow account until each expense is due.  When taxes and insurance premiums go up each year, so does the borrower’s monthly payment.

In an ideal world, this system of escrow would flow seamlessly, with borrowers having sufficient notice of increases, deficits or other problems. Unfortunately, lenders do not always properly calculate estimated payments, pay taxes and insurance on time, or communicate necessary changes to borrowers in a timely manner. Since many mortgages are sold to a new lender shortly after closing, this presents the opportunity for even more problems with a newly established escrow account. In light of the numerous problems and abuses of the escrow system, legislators attempted to regulate the practice to protect consumers.

In 1974, Congress passed the Real Estate Settlement Procedures Act (RESPA) which, among other things, outlines requirements for escrow accounts.  Once administered by the Department of Housing and Urban Development (HUD), as of July 2011, the Act now falls under the administration of the Consumer Financial Protection Bureau (CFPB).  The regulations outlined in RESPA are only intended to serve as a minimum guideline, with certain agencies, such as FHA and VA, including additional rules regarding escrow accounts for loans under their jurisdiction.

Furthermore, some states also include additional requirements above what is required under RESPA. Some states require lenders to establish an escrow account for taxes, hazard insurance or private mortgage insurance (PMI). Other states allow lenders to establish voluntary escrow policies, provided those policies follow state guidelines. For example, the state of Illinois stipulates how much a lender can hold in escrow.  Alternatively, states such as Missouri not only require escrow accounts, but regulate their management.

With so many regulations, it is hard to imagine that a lender could make a mistake regarding escrow. Unfortunately, mistakes, miscalculations and other problems with escrow accounts are numerous. Borrowers have remedies, should a lender fail to make timely payments or require escrow payments in excess of taxes, insurance premiums or other costs. In the meantime, however, borrowers are subject to late tax penalties, insurance cancellation and other risks.

According to RESPA, lenders who utilize escrow accounts must establish such an account at closing. The seller is responsible for a pro rated portion of the accrued taxes on a property up to the date of closing. This money is collected at closing, along with funds from the buyer to establish an escrow account. Monthly escrow payments going forward are then estimated by the lender and added to the monthly mortgage payment. Unfortunately, lenders often underestimate and thus, under charge, leaving a deficit in the escrow account when taxes and insurance premiums come due.

If there is not enough money in the borrower’s escrow account to pay taxes, insurance and other expenses, the lender has two options. A bill can be sent to the borrower, requiring immediate payment of any deficit. Alternatively, the lender can roll the deficit into future escrow payments and increase the amount of the borrower’s monthly payment. Either way, the borrower can be left with a hefty unexpected bill or a substantial increase in monthly payment amounts, with no options but to pay or risk losing their investment.

No matter how much assurance a lender offers at closing regarding the accuracy of escrow payments, buyers should cover themselves in the event of issues. Establishing a personal savings account is the smartest option. Should a substantial increase in taxes or insurance occur during the first year or two of a mortgage, savings can be used to pay a shortage voucher, preventing exorbitant mortgage payment increases. While borrowers legally do not have to cover penalties or fines related to late tax or insurance payments covered by escrow, few laws protect the borrower from expensive corrective measures initiated by the bank should estimated payments fall short of expenses. As such, having an emergency fund can make all the difference.