How Does an Escrow Account Work With an FHA Loan?

An FHA loan doesn’t require you to put much down, but you should expect your payments to include extra money due to escrow requirements. FHA loans require that you escrow for property taxes, homeowners insurance and private mortgage insurance. The account will be set up at closing, and each of these items will add to your monthly payments.

Property taxes are the biggest item escrowed on FHA loans. Obtain a copy of your tax bill from your municipality and submit it to the lender. The lender will divide your yearly tax payment by 12 to determine the monthly amount. For example, if your taxes are $4,000 per year, your monthly payment will be $333.33.

You will pay a certain amount of property taxes up front, as part of your closing costs. The bank will collect these payments from you monthly and submit them to the taxing authority as they come due.

As with property taxes, the bank takes your yearly homeowner's insurance premium and divides by 12, so if you pay $450 per year, then you pay the bank $37.50 per month. At closing, the bank collects your full first year’s premium to put the policy in effect. It will then collect the monthly escrow amount from you for a year. When you renew your policy, the bank takes that money collected over the prior year and pays for the policy renewal.

Private mortgage insurance, also known as PMI, is a premium you pay when you put down less than 20 percent on a home purchase. The premium is calculated based on a percentage determined by your loan to value ratio. This varies by bank.

For example, if you purchase a house for $200,000 and put only 3 percent down, your mortgage will be $194,000, giving you a loan-to-value of 97 percent. If your bank charges 0.90 percent for that LTV range, multiply $194,000 by 0.009. This gives you a yearly premium of $1,746. Divide that figure by 12 to get $145.50, your monthly PMI payments.

Your fixed principal and interest will stay the same unless you refinance the loan. This isn’t the case for escrow payments, however. Your taxes or insurance can go up or down, changing your payments with it.

If you’re lucky enough that your payments go down, the bank will issue you a refund check at the end of the year. If your payments increase, you’ll have to cover the shortage. You’ll be given the unenviable decision of paying a lump sum or spreading those payments out over the next year. Fortunately, once your property reaches 78 percent LTV, you can request that PMI be canceled, saving you a nice chunk of change each month.