Trying to understand how an escrow account works might be confusing at first, but as a homeowner you should know where your money is going. Escrow accounts are used to pay for miscellaneous expenses such as property taxes and homeowner's insurance. The lender is allowed to collect additional money to keep in the account as overage in case the bills are higher than anticipated. However, there are laws in place that limit the overage amount the bank can keep in your escrow account.
Escrow Basics
When you take out a mortgage loan to buy a house, the lender holds an interest in the property until the loan is paid in full because the property acts as collateral. The lender wants the property taxes and homeowner's insurance premiums to be paid on time. Failure to pay these can result in a tax lien or total loss of your home due to a disaster without coverage. Either of these circumstances jeopardizes your lender's interest in the property. Establishing an escrow account puts the lender in control of these payments. Each month, the lender collects an additional amount with your mortgage payment and places it in an escrow account. When tax or insurance bills are due, the lender pays them on your behalf.
Calculations
The lender determines how much to collect each month based on some straightforward calculations. First, the lender totals the yearly amounts owed for taxes and insurance. The total is divided by 12 to reach the monthly contribution. For example if you owe $4,000 per year in property taxes and $800 for homeowner's insurance the total is $4,800. This is equal to 12 monthly payments of $400. Lenders analyze escrow accounts each year to factor in changes to the tax rates or premiums. Over time, these rates change -- usually increasing -- at the discretion of the tax collector or insurance company. You receive this information in a summary when it's completed.
Cushion
Lender's can generally estimate what you will need for escrow without mistakes. However, there's a chance that their estimates are off. To cover for this, the lender collects overage -- usually called a cushion -- to hold in your escrow account. By law, the lender is allowed to collect up to two months of additional payments to hold as an overage. In the example used, this would equal $800 a year or approximately $67 dollars a month.
Considerations
Even with the overage amount, your escrow account might still be short on funds if a bill is much more than expected. In this case, the lender will likely cover the difference. Then the lender will send you a notification that your escrow was short and you now owe the overage. You should have the option to pay a lump sum or spread the payments out over the next year. Conversely, the lender might overestimate the bills and you will be left with a surplus. In this case, the lender sends you a check or lowers your escrow payments for the next year. For tax deduction purposes, you can only claim the amount paid out of your escrow to the property tax collector. You can't claim the overage you paid into the escrow.