Paying a mortgage means you're striving for the financial security of home ownership. From the perspective of your lender, however, you're an investment that carries risk. For that reason, lenders almost always protect themselves by requiring an escrow account, out of which they pay the essential expenses of property taxes and insurance. Though this ensures these payments continue, they also set up a reserve, funded 100 percent by a portion of your monthly payments.
To protect their loan, mortgage lenders usually require borrowers to fund an escrow account, along with their mortgage principal and interest payment, out of which the mortgage servicing company pays property taxes, property insurance, mortgage insurance (if required) and other essential expenses. Without an escrow account, the borrower who fails to maintain insurance and pay taxes on the home may lose the property that secures the loan.
The Reserve Fund
The mortgage company sets up a reserve fund to ensure the escrow account has sufficient funds to pay expenses, even if the borrower starts missing payments. The mortgage servicer calculates the amount of the reserve and bills the borrower to fund the reserve, adding that amount to the monthly payments. The calculation used to set the reserve varies. A common practice is to take the previous year's expenses, divide by 12 to get a monthly amount and set the reserve at an amount equal to two months of escrow payments.
Initial Escrow Funding
When you close on the house, the terms "escrow" and "reserve" are really synonymous, since there have not been any payments yet made for taxes and insurance yet. Instead, the lender sets up the escrow account by setting the reserve at 14 months (in most cases) of payments toward insurance and taxes. The lender then subtracts the number of months until the first payment and charges you the balance at closing. If there are nine months until the first property tax payment will fall due, for example, then you will need to come up with five additional months of escrow funds dedicated to taxes at the closing.
Laws and Mandates
Different lenders, and different state laws, vary in their treatment of escrow reserves. In New York, lenders are required to pay interest on any escrow balances. If the lender requires a cushion, the amount can't exceed 1/6 of the total escrow amount needed annually. In Vermont, reserves are permitted, but the lender must conduct an annual escrow account analysis to determine the borrower's monthly escrow payments for the following year based on the borrower's tax liability. Some lenders, such as Wells Fargo, require escrow reserves on all mortgages with less than a 20 percent down payment, while others will allow a borrower to request a waiver of the reserve.
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