When you and your spouse buy your first home, you will probably obtain a mortgage to finance it. At your mortgage closing, the lender may require you to pay money into an escrow account. Mortgage escrow accounts hold funds that your lender uses to pay your property taxes and home insurance expenses during the year.
Purpose of Escrow Accounts
Lenders require borrowers to hold escrow accounts to prevent a home's property taxes from becoming delinquent. Because the lender will need to use the collateral to recover the cost of the loan if you default, it wants to protect the property from damage and the claims of other creditors. If property taxes are delinquent, the taxing authority can impose a lien on the title to the home, which compromises the lender's claim on the property. For this reason, the lender elects to collect funds from the borrower and pay the property taxes itself. Lenders also use the funds in the escrow account to pay for home insurance, which protects the home against losses related to damage.
To determine how much money you must pay into your escrow account each month, your lender first determines your annual home insurance and property tax obligations. By dividing the sum of your insurance and taxes by 12, the lender can determine how much money you need to pay into the account each month to break even. Lenders may also require you to keep a cushion in the account. At closing, you will deposit the amount of the cushion along with the amount required to bring the account balance current for that point in the year.
Escrow accounts are regulated by the Real Estate Settlement Procedures Act. RESPA doesn't require lenders to hold escrow accounts for borrowers, nor does it prohibit them from doing so. However, RESPA does limit the amount that lenders can hold as a cushion in the account to one-sixth of the account's total obligations during the year. RESPA also stipulates that the money in the account be used only to pay real estate taxes and home insurance expenses.
When a lender holds an escrow account on your behalf, it is legally obligated to make your property tax and home insurance payments in full and on time. RESPA requires lenders to perform escrow account analysis once each year to ensure that the balance in the account covers your obligations but doesn't exceed the allowable limit. If your account balance is too high, the lender must issue a refund. Though most lenders require borrowers to maintain escrow accounts, some lenders allow borrowers to opt out of their escrow account after the mortgage's loan-to-value ratio drops below a set amount.