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.

When the Great Recession hit the United States in 2008, the primary reason given for the financial collapse was bad mortgages. The biggest culprits were the sub prime mortgages given to people who, in reality, could not afford the homes they were buying.

Another problem that led to financial collapse was the artificial inflation of home values. Homes that should have been valued at $100,000 were suddenly getting valued at $300,000. Lenders were giving out mortgages or refinanced mortgages based on these inflated values and when the market bottomed out, homeowners were left with inflated mortgages they could not pay.

Rather than finding ways to pay their inflated mortgages, people started to leave their homes and accept foreclosure. We have all seen the financial effects that mass foreclosures can have on the global economy. But aside from losing your home, there are several good reasons why you should avoid foreclosure at all costs.

Deficiency Judgments

A common misconception about foreclosure is that, once the process is done, the former homeowner is off the hook for the remaining balance of the mortgage. Nothing could be further from the truth. A foreclosure works exactly like car repossession. The bank takes possession of the property, auctions the property off and applies the amount received at auction to the remaining balance of the loan. The difference between the auction proceeds and the balance left is sought out in a deficiency judgment. This is a legally binding court order that puts the former homeowner on the line for the remaining mortgage balance.

If your home was repossessed with a remaining mortgage balance of $200,000 and the house was sold at auction for $80,000, then you are responsible for that $120,000 difference. The bank can seize your assets, garnish your wages and keep taking from you until the debt is paid.

Sustained Credit Damage

A foreclosures stays on your credit report for seven years, which is three years less than a bankruptcy. But the immediate and sustained damage to your credit score is much more dramatic with a foreclosure than it is with a bankruptcy.

A foreclosure can cause as much as a 300 point drop in your credit score which could remain that way for several years. A bankruptcy can create a drop of around 200 points, but credit can be rebuilt almost immediately after a bankruptcy is filed. It can take years for a consumer to get any kind of credit after a foreclosure.

Credit Report Effects

Because a foreclosure causes an immediate and significant drop in your credit score, it can have an adverse effect on everything affected by your credit report. If you need to get government security clearance for your job, then you may experience issues with the foreclosure.

To some potential employers and apartment landlords, a foreclosure indicates a lapse in responsibility. That foreclosure could cost you a new job, a promotion and the chance to live in the apartment of your choosing.

Lost Value

One of the things that homeowners fail to keep in mind when they allow a home to go into foreclosure is the investment of time and money they will lose in the work they have done on their home. A major remodeling project that costs thousands of dollars and took weeks to complete is gone in the wink of an eye. The new roof you just installed, the new furnace and air conditioning system you had put in and the new landscaping you just paid for are now all gone.

Not only that, but if you financed any of those major improvements then you will be stuck paying for something that you no longer own. The financial loss of a foreclosure is not limited to the value of your property. It also extends to any money you put into your home that you are still paying on.

It Isn’t Necessary

The biggest reason to avoid foreclosure is that it isn’t necessary. If you know that you are unable to pay your mortgage then you have two options; sell your home or talk to your lender.

If the value of your home is not too over-inflated, then you can sell it at the break-even point and get out of the mortgage without any further damage to your credit. As a matter of fact, paying the mortgage off by selling your home satisfies the debt and stops the negative effect it is having on your credit score.

Read your mortgage to see what options exist if you run into financial problems. Do not avoid your lender when times get tough. Give your lender a call and discuss your options. The federal government also has options you can explore to avoid foreclosure as well. Remember, your bank wants you to keep your home, so call and talk to a representative before things get out of hand.

Walking away from a mortgage can sound like an easy way to get out of a debt. But a foreclosure will follow you for years and could wind up being much more trouble than you expected. Explore your options and do everything you can to avoid foreclosure.