If you purchase a home, property or any type of dwelling, chances are you might wonder what is an escrow account and do you need one?
What Is an Escrow Account?
An escrow account is essentially a savings account that is utilized by the mortgage lender to pay recurring financial obligations on behalf of a homeowner, which may include:
- Homeowners Insurance
- Property Taxes
- Private Mortgage Insurance
Escrow accounts may only be used to pay these items and not interest fees, late fees or penalties.
Earnest money given when offers to purchase property are also placed into escrow to ensure a buyer's commitment. These types of accounts are usually set up by the title company and are only utilized for earnest money.
Funding the Account
A mortgage company or lender, or mortgage servicer, sets up the account and uses it to pay for insurance and property tax only. For example, the monthly payment on your mortgage may be eight hundred dollars. The eight hundred may be broken down as follows:
$400 goes to mortgage principal
$200 goes to interest on the loan
$200 goes into the escrow account
When it is time to pay property taxes and annual insurance premiums, the lender utilizes the dollars accumulated in the account to pay for those items.
Is an Escrow Account Mandatory?
This often depends upon the lender. Some financial institutions require an escrow account be opened to ensure taxes and insurances are paid on time. On the other hand, some mortgage companies will allow a client to purchase required insurances on their own and pay both these and the property taxes in a timely manner.
If you have a mortgage with no escrow account and miss insurance premiums or property taxes, the mortgage company will be notified as lienholder that premiums and taxes are in arrears. If this happens, they will notify you they have the right to obtain insurances and pay property taxes on your behalf and may charge you hefty fees.
Some escrow accounts are interest-bearing savings accounts but interest earned is also income earned, meaning it is taxable. If you have this type of escrow savings account, ask your lender about the amount of interest earned and make sure they send you an interest income earnings statement annually to file with your tax return.
Paying Taxes and Insurance
Most mortgage lenders/servicers pay insurance and taxes directly on the homeowner's behalf. Some lenders offer alternatives to borrowers when the time comes to pay these items:
- You can request the lender to send you a check for insurance premiums and taxes, however, keep in mind those checks will need both your endorsement and the insurance company or municipality where the property taxes are due.
- You can submit insurance invoices and property tax bills to your lender well in advance in order for them to make a timely payment on your behalf. It is important to note, however, that in the majority of instances these invoices are already sent directly to your mortgage company so you may not have to send these documents to your mortgage company at all.
Summing Up Escrow Accounts
Finally, when considering what is an escrow account and do you need one, if you are purchasing property through a real estate land contract where the seller carries your loan, request they set up an account with an escrow company. This way you will make payments to the escrow company and not the seller. The escrow company will keep track of the interest paid and send you an annual interest paid statement to utilize as a deduction at tax time. If you simply pay the seller, they may not offer this service.
Escrow accounts are an easy way to make sure your insurance premiums and property taxes are paid on time. If you want to do this on your own, ask your lender if an escrow account is required.