As part of a mortgage loan transaction, a lender commonly requires the borrower to agree to pay property taxes and keep homeowners’ insurance on the property. So, the servicer sometimes collects extra money from the borrower each month, along with the principal and interest.
The servicer puts this extra money in a designated account called an "escrow account" or an “impound account” (in some states). When the property taxes and homeowners’ insurance bills are due, the servicer pays these bills with money from the escrow account.
But homeowners sometimes prefer to pay the taxes and insurance themselves. Yet, some loans require an escrow account, and, in some cases, it's just easier to have one.
How a Mortgage Escrow Account Differs From Escrow When You Buy a Home
Escrow that accompanies a home purchase is short-lived and involves a neutral third party, like an escrow agent, title agent, or escrow company. This agent holds funds, such as earnest money or important documents, like the deed from the seller transferring the property to the buyer, before closing the sale.
A mortgage escrow account is different from the type you had when you bought your home. Throughout the life of your mortgage, you, of course, pay monthly amounts of principal and interest. If the lender also sets up a mortgage escrow account, you’ll also pay about one-twelfth of the estimated annual cost of property taxes and homeowners’ insurance each month to the servicer. Sometimes, the lender also requires amounts sufficient to cover homeowners’ association dues and mortgage insurance as part of an escrow account.
Example. If your property taxes and insurance add up to $6,000 a year and you have an escrow account, you’ll pay $500 each month in addition to your principal and interest payment. The servicer deposits this money into the escrow account. The servicer then pays the tax bills and insurance premiums out of this account when the bills become due, usually once or twice a year.
Because the cost of taxes and insurance can fluctuate from year to year, you might also have to pay some additional money into the account, usually two months’ worth of escrow payments. The servicer can use this money, called an escrow "cushion," to pay for unexpected increases in the property taxes or homeowners’ insurance.
What Is the Purpose of a Mortgage Escrow Account?
By insisting that the borrower pay a little bit each month into a tax and insurance escrow account and taking responsibility for paying those bills, the lender ensures that money will be available to cover these important costs and that the payments won’t inadvertently be skipped.
Why the Lender Is Concerned About Property Taxes
If your property taxes aren't escrowed as part of your mortgage loan, and you don't pay them, the overdue amount becomes a lien on your home. In most cases, property tax liens have priority over other liens, like a mortgage lien. Because this type of lien has priority over a mortgage, the lender faces the prospect of its lien being wiped out if your home is sold through a tax sale.
To make sure this doesn’t happen, the lender (via the servicer) will usually pay delinquent property taxes for you out of its own funds. (Most mortgage contracts require the borrower to stay current on the property taxes and allow the servicer, on behalf of the lender, to pay them if the borrower doesn’t.)
After the servicer advances money to pay the delinquent taxes and any penalties owed, it will usually turn around and demand repayment for these amounts, plus interest, from you, the homeowner. Along with demanding repayment of the amount that it paid for the taxes, penalties, plus interest, your servicer might set up an escrow account for the loan.
Failing to pay the taxes constitutes a default under the loan contract terms. So, if you don't pay them or reimburse the servicer for any taxes it paid, the servicer can then foreclose on the home in the same manner as if you had fallen behind in mortgage payments.
Why the Lender Is Concerned About Homeowners' Insurance
A house in good condition because insurance money was available to fix damage after a fire or other casualty brings in more money at a foreclosure sale than one left to fall apart. So, the lender also wants to ensure the insurance premiums get paid.
The terms of most mortgages require homeowners to maintain adequate homeowners' insurance. If you let this insurance coverage lapse, the servicer can order insurance coverage at your expense. This type of insurance is called "force-placed" or "lender-placed" insurance. The servicer may then charge you for the cost of the lender-placed insurance.
Failing to pay the insurance constitutes a default under the terms of the loan contract. So, much like unpaid property taxes, if you don't pay for insurance or reimburse the servicer for any amounts it paid, the servicer can then foreclose on the home in the same manner as if you had stopped making monthly mortgage payments.
Federal Law Governs Force-Placed Insurance
The Real Estate Settlement Procedures Act (Regulation X) restricts how and when a servicer may buy force-placed insurance on a borrower’s behalf.
A servicer must have reason to think you don’t have coverage. Under Regulation X, a loan servicer can’t buy force-placed insurance for your property unless it has a reasonable basis to believe that you failed to maintain insurance coverage as required by the mortgage or deed of trust. For example, suppose your insurance company calls the servicer and says that the bill is overdue. That call provides a reasonable basis for the servicer to think that there's no coverage.
A servicer must send you certain notices before force-placing insurance. The servicer must send you certain notices before purchasing a force-placed insurance policy. The notices must ask that you:
- get homeowners’ insurance for the property, and
- send the servicer proof of insurance, like a copy of the insurance policy declaration page, an insurance certificate, or the policy.
When the servicer must send the notices. The servicer must first send a notice at least 45 days before buying a force-placed insurance policy. The servicer then has to send a second notice, a reminder notice, no sooner than 30 days after the first notice and at least 15 days before charging a borrower for force-placed insurance coverage. The second notice has to include the cost of the force-placed insurance or a reasonable estimate of the cost.
What happens if a borrower gives proof of insurance coverage to the servicer. If the borrower then gives the servicer proof that insurance coverage is in place, the servicer has to:
- cancel the force-placed insurance within 15 days after getting proof that there is existing insurance, and
- refund any premiums that the servicer charged the borrower while there was duplicate coverage.
What to Do If Your Servicer Improperly Force-Places Insurance on Your Property
It's not uncommon for a servicer to wrongfully buy expensive force-placed insurance for a borrower’s home even though the borrower already has other coverage in place and, sometimes, even after the borrower provides evidence of that insurance. Because force-placed insurance is expensive, a homeowner who's already struggling to make payments or is already behind in payments might go into foreclosure when it becomes even more difficult to get current on the loan.
If your servicer improperly puts insurance on your home, you may send the servicer a “notice of error.” Under federal law, if you send your servicer a notice of error (basically, a letter) letting the servicer know that it made a mistake on your account, the servicer must fix the mistake within a specific time period.
You can also use a notice of error if the service makes a mistake concerning the property taxes.
Some Loans and Lenders Require Escrow Accounts
If you have a specific type of loan or if your lender requires it, you must have an escrow account. But you might be able to cancel the account at some point.
Conventional Loans: Escrow Accounts Are Optional
With a conventional loan, the lender decides whether to set up an escrow account. Many mortgages have a clause that gives the lender the ability to establish an escrow account basically at any time it chooses. The servicer actually sets up the account.
In most cases, the lender will insist you have an escrow account if your down payment is less than 20% of the purchase price for the home. But, if you make a down payment of 20% or more, your lender might not require an escrow account. The reasoning behind the lender’s willingness to waive the escrow account is its belief that because you have relatively high equity in the house, you’ll be motivated to save enough money to pay the tax bills and insurance premiums.
If you can’t afford to put 20% down when you take out the loan and don’t want an escrow account, you might be able to cancel the account once you reach 20% equity in the home. In most cases, you also must have had the loan for at least a year and can't have any late payments during that time. If the lender cancels the escrow account and later finds out you haven’t paid the taxes or insurance, it will probably set up an escrow account for you at that time.
Federal Housing Administration (FHA-Insured) Loans: Escrow Accounts Required
If the Federal Housing Association (FHA) guarantees (insures) your mortgage loan, you must have an escrow account. With an FHA-insured loan, if you breach the mortgage agreement and your house isn't worth enough to fully repay the debt through a foreclosure sale, the FHA will compensate the lender for the loss. Because the FHA wants to limit its losses, it requires escrow accounts on FHA-backed loans to ensure that the taxes and insurance are current.
U.S. Department of Veterans Affairs (VA-Guaranteed) Loans: Escrow Accounts Usually Required
The U.S. Department of Veterans Affairs (VA) doesn’t specifically require lenders to set up escrow accounts on VA-guaranteed loans. However, the VA says that it is the lender’s responsibility to ensure homeowners with VA-backed loans pay property taxes and have homeowners’ insurance. So, to comply with this requirement, most lenders that make VA-guaranteed loans set up escrow accounts for borrowers.
Higher-Priced Mortgage Loans: Escrow Accounts Required
Under federal law, lenders must set up an escrow account if the borrower takes out a “higher-priced” mortgage loan. “Higher-priced” mortgage loans are, in general, loans with an annual percentage rate (APR) that is higher than the average interest rates, fees, and other terms on mortgages offered to highly-qualified borrowers. In most cases, the escrow account must continue for at least five years. After five years, you can cancel the escrow account if the unpaid balance of the loan is less than 80% of the original value of the property and you have no delinquent payments.
How to Get Rid of a Mortgage Escrow Account
Every lender has different terms for getting rid of an escrow account (if deleting the account is allowed). Sometimes, the loan must be at least one year old with no late payments. Another requirement might be that no taxes or insurance payments are due within the next 30 days. Contact your loan servicer to find out if you qualify for a deletion of the account.
Why You Might Want to Keep or Cancel Your Escrow Account
It would be a mistake to automatically conclude that avoiding or canceling an escrow account’s always in your best interests. True, your payments will be lower each month without one, but you might be better off with one. Consider the following points.
If you’re not good at setting money aside to pay large bills that will come due later, having an escrow account might be a good idea. Having an escrow account makes it easy to save money to pay taxes and insurance because you contribute small amounts toward them with each mortgage payment. Also, when you have an escrow account, you don’t have to worry about forgetting to pay the taxes or insurance. If you forget to pay the property taxes, your state or local government might charge you a penalty or place a tax lien on your home. You could then face a foreclosure by the taxing authority (if it has a lien on your home) or by the lender (if the lender pays the taxes for you and you don’t reimburse the lender). Also, you'll probably have to give the servicer evidence you've paid the taxes and insurance, which can be an inconvenience.
On the other hand, if you’re good at saving money, you might not want an escrow account. By putting the money in a savings account rather than an escrow account, you can earn interest until you have to pay the taxes and insurance. Generally, the lender doesn’t have to pay you interest on money in an escrow account, although a few states require it. If you decide that you’d rather pay the taxes and insurance yourself, contact your servicer to see if you can cancel your escrow account.
Getting Help
If you have further questions about how an escrow account works, including the pros and cons of having one, consider talking to a real estate attorney. If you’re facing a foreclosure and have questions about the process, ways to avoid it, or whether you have any potential defenses, consider consulting with a foreclosure lawyer.
And if your servicer doesn’t respond to your notice of error, consider talking to an attorney or a HUD-approved housing counselor. You may also file a complaint with the Consumer Financial Protection Bureau (CFPB). The CFPB will send your complaint to the servicer and try to get a response, normally within 15 days.
