If you are a first-time homebuyer, you probably have noticed that there is a whole language that you have to learn as a homeowner. We promise, it gets easier, but it can be a huge help to get some background information on the lingo you’ve been hearing. To that end, Brian M. Douglas & Associates wants to help get you started on the right foot with a little Homeowner 101. Today’s lesson: what is an escrow account?
The word “escrow,” used in different contexts can mean slightly different things. In the world of homeownership, an escrow account is a special account that you fund and a bank (or other financial institution) manages for you. The purpose of an escrow account is to make it easier to pay the costs associated with homeownership.
Each month, homeowners make one payment into their escrow account. This payment includes the monthly mortgage payment, as well as prorated monthly contributions to real estate taxes, homeowners insurance, and mortgage insurance. Unlike mortgage payments, which are due every month, these other costs are only paid once a year. By contributing to an escrow account, the homeowner can make smaller monthly payments over the course of the year rather than having to come up with a lump sum payment for each. When each of these bigger bills comes due, the financial institution holding the escrow account simply withdraws the full amount and pays the bill on time.
How Does a Bank Determine the Amount a Homeowner Should Contribute Per Month?
A bank, or any other financial institution that manages escrow accounts, will determine how much a homeowner should pay monthly into the account by determining what he or she will pay over a twelve month period in real estate taxes, homeowners insurance, and mortgage insurance. These amounts are based on estimates using previous years’ data. Some states allow for a little extra money to be contributed as well to offset any potential increases in costs. Once adding together these yearly costs, a bank will divide the amount by twelve and then add that prorated amount to the homeowner’s monthly mortgage payment.
Let’s take a look at an example. Homeowner Harry pays $1,800 per month toward his mortgage. Each year, his real estate taxes amount to about $3,000 and his homeowners’ insurance premium is $1,200. He also pays an annual premium of $1,500 for mortgage insurance.
Harry’s annual costs are:
$3,000 (real estate taxes) + $1,200 (homeowners’ insurance) + $1,500 (mortgage insurance) = $5,700
Divided over a twelve month period, Harry’s monthly contribution to these costs equals $475. Added to his monthly mortgage payment, Harry will contribute $2,275 into his escrow account each month. When the real estate taxes, homeowners’ insurance premium, and mortgage insurance premium are due, the bank will simply make those payments on Harry’s behalf out of his escrow account.
What if the Contributions are Not Enough to Cover the Actual Annual Costs?
Since the monthly contributions are based on estimated costs, it is possible that the actual real estate taxes may be higher than expected. If it happens that a homeowners’ actual annual costs exceed the amount being held in escrow, most banks offer two options.
The first is that the homeowner will be notified of the deficit and is given the opportunity to simply pay the balance into escrow to cover the full annual costs. A second option is that the homeowner may decline to pay the difference between the amount held in escrow and the amount owed to the state and/or local government. In this instance, the bank will cover the shortage and then increase the homeowners’ monthly contribution amount to repay the difference.
What if the Contributions Exceed the Actual Annual Costs?
If at the end of the year, the actual costs are less than the amount being held in escrow, the bank will simply return the excess to the homeowner. If the excess amount is relatively small, some financial institutions may roll the amount over into the next year.
What are the Pros and Cons of Using an Escrow Account?
For the most part, using an escrow account to pay annual homeownership costs is a convenient and easy way to budget for these large expenses and ensure they are paid on time. In our experience, the majority of homeowners prefer to use an escrow account to manage their homeowners’ bills. However, some homeowners do not like the concept of an escrow account. This is because not all escrow accounts are interest-bearing, so some homeowners see escrow accounts as an interest-free loan to the financial institution.
Are Escrow Accounts Required for all Homeowners?
Some mortgage lenders require homebuyers to use an escrow account. For example, the Federal Housing Administration (FHA) requires that borrowers have an escrow account to pay homeownership costs. However, not all lenders require the use of an escrow account, and others offer an opportunity to cancel an escrow account if the homeowner is able to show a history of on-time payments.
Contact an Experienced Atlanta Real Estate Attorney to Learn More
If you are a first-time homebuyer or if you simply would like to learn more about escrow accounts in the State of Georgia, feel free to reach out to Brian M. Douglas & Associates. Our experienced Atlanta real estate attorneys are always happy to answer questions and help in any way we can. To make an appointment, give our office a call at (770) 933-9009.