Mortgage escrow accounts are a fact of life for most people with a mortgage. In most cases, your escrow account runs in the background and you probably don’t think about it unless something goes wrong. You just make your monthly mortgage payment and a portion of it goes to the lender, and the other portion goes to the escrow service, which holds the money you send them in an account which is then used to pay your property taxes and homeowner’s insurance when they are due.
Most people with an escrow account have it because it was required by their lender when they purchased their home. (Most lenders require escrow accounts for first time homebuyers or when you don’t put down much when you make the purchase.) The escrow account helps lenders protect their investment and makes it easier for many homeowners to budget for their property taxes and homeowners insurance because they make the payments on a prorated basis – you can think of it as a forced savings account.
While escrow accounts may be required and offer a simpler way of doing things, there are both advantages and disadvantages to using escrow accounts.
Benefits of mortgage escrow accounts
The main benefit of using an escrow account is not having to come up with a large payment every 6 months or so for your property taxes or annually for your homeowners insurance. When everything works as advertised, you will have contributed an equal portion of these bills in the months leading up to their due date. In this sense, the escrow account works as an accrual account.
The other benefit for the homeowner is not having to worry about sending in these payments when they are due, because the escrow company should take care of them for you – trust me, you don’t want to miss out on your tax payments!
Unfortunately, sometimes things go wrong, which is one of the major disadvantages of escrow accounts.
Downfalls of mortgage escrow accounts
There are several downfalls to escrow accounts. Basically, you are paying someone to do something you could do yourself (make payments on a schedule). Other downfalls occur when escrow accounts don’t work properly, when there is an overage or shortage, and due to missed opportunity cost.
When escrow doesn’t work
The biggest downfall of an escrow account is when things get mucked up, regardless of who is at fault. Many mortgages are bought and sold, which sometimes causes a change in the escrow company. Sometimes things get messed up in the transition. Other problems can occur if your escrow company misses a scheduled payment, or if your escrow company goes broke. Your escrow company may be FDIC insured, but it still may take some time to get your funds, which may delay your property tax or insurance payments.
Escrow shortfalls and overages
Another downside to escrow accounts is that they are set for your last property tax rate or homeowners insurance rate. If property tax values change, you may find yourself with an overage or a shortfall (either too much or too little money in escrow). An overage is no big deal, you simply paid too much and missed out on a little bit of interest that you could have used if you had your money stashed in a savings account.
An escrow shortfall, on the other hand, can be a big deal. This happens when you don’t have enough money in your escrow account and your tax or insurance bill causes your escrow account to run low. Your escrow account may cover the shortfall (you are usually required to have a buffer in your account), but you will need to replace your buffer and pay more on your mortgage payments in the months that follow to both replace the buffer that was depleted and to make up for the higher tax or insurance rates you are paying.
Escrow shortfalls and overages are one of the most common reasons your mortgage payment can change even with a fixed rate loan. This happened to my wife and I twice in the first two years we were married, one time $150 per month, the other time about $10 per month. Thankfully, both of these were reductions in our mortgage payments!
*One a side note, the recent housing slump has caused home prices to drop in many areas, which may make it a good time to challenge your property taxes. This was how we had a drop in our mortgage payments.
Missed opportunity cost
The final downfall to using a mortgage escrow account is that the average homeowner usually has several thousand dollars tied up in escrow at any given time, money which could be earning you interest instead of someone else.
Should you use an escrow account?
Looking through this list, it seems as though the cons outweigh the benefits, and as I mentioned earlier, you are basically paying someone to do something you can do yourself. So why even bother with an escrow account?
The answer for many people is easy: it is required by the lender. Some lenders won’t even give you an option of doing away with your escrow account unless you an prove you have a certain amount of funds on hand or you own a certain percentage of your property.
There are other reasons to use an escrow account, which mostly boil down to convenience. It is easy to set up automatic payments to your escrow account, so you can send in a monthly payment toward your property taxes. They also send in the check, removing the responsibility from you.
In fact, I even know people who own their house and continue to use an escrow account because they can set it on autopilot and don’t have to worry about making payments when they are due. Owning their home reduces the risk of their escrow company changing, and thus reduces their worry. It’s a small price to pay for peace of mind.
What are your thoughts on mortgage escrow accounts? Good, bad?