When navigating the complexities of home buying and mortgage lending, escrow accounts play a pivotal role. However, it's essential to distinguish between the different types of escrow accounts and their distinct uses: 1.) The Earnest Money Deposit (EMD) Escrow Account, usually held by the Title Company or the Real Estate Brokerage and 2.) The Lender's Escrow Account.
The Earnest Money Deposit (EMD) Escrow Account
Definition and Purpose:
EMD Escrow Account: This account is used to hold the earnest money deposit from the homebuyer. The earnest money deposit is a good-faith deposit made by the buyer to demonstrate their serious intent to purchase the property.
Purpose: It ensures that the buyer is committed to purchasing the home, and it protects the seller in case the buyer backs out of the deal without a valid reason.
Process:
Deposit: Once the purchase agreement is signed, the buyer deposits the earnest money into an escrow account, typically managed by a third-party escrow agent or a title company.
Holding Funds: The escrow agent holds the funds until the transaction closes.
Application of Funds: At closing, the earnest money is applied towards the buyer's down payment or closing costs. If the deal falls through due to contingencies outlined in the purchase agreement (such as a failed inspection), the buyer may get their earnest money back.
Protection and Security:
The EMD escrow account provides security for both parties: sellers are assured of the buyer's commitment, while buyers know their funds are protected until the terms of the purchase agreement are satisfied.
The Lender's Escrow Account
1. What is a Lender Escrow Account?
An escrow account, in the context of mortgage loans, is a separate account that the lender sets up to pay certain property-related expenses on behalf of the borrower. These expenses typically include property taxes and homeowners’ insurance. Each month, the borrower pays a portion of these costs along with their regular mortgage payment, which the lender then holds in the escrow account until the bills are due. The lender ensures these bills are paid on time, which helps protect their interest in the property. It also simplifies things for the borrower since they don’t have to worry about paying lump sum tax and insurance bills once due.
2. When Are Lender Escrow Accounts Required?
Required:
- FHA and VA Loans: Government-backed loans usually require escrow accounts to ensure that property taxes and insurance are paid.
- High Loan-to-Value (LTV) Ratios: Borrowers with high LTV ratios (i.e., smaller down payments) may be required to have an escrow account because the lender considers them higher risk.
- State Requirements: Some states mandate escrow accounts under certain conditions, regardless of the type of loan.
- Lender Policy: Some lenders have internal policies requiring escrow accounts for all borrowers to mitigate risk.
Not Required:
- Conventional Loans with Low LTV: Borrowers with conventional loans and significant equity (low LTV) might not be required to have an escrow account.
- High Credit Scores: Borrowers with excellent credit scores and a strong repayment history might have the option to waive the escrow account.
- Paid Mortgage Insurance: If private mortgage insurance (PMI) is not required, lenders might allow the borrower to manage their own tax and insurance payments.
- State-Specific Regulations: Some states allow borrowers to opt-out of escrow accounts under specific conditions, usually involving higher creditworthiness and lower LTV ratios.
3. How Lender Escrow Accounts Impact Cash to Close
When setting up an escrow account, the borrower needs to pre-fund it to ensure there are sufficient funds to cover upcoming property tax and insurance bills. This pre-funding is part of the closing costs and can significantly impact the total cash required to close the mortgage. The exact amount needed to pre-fund the account won’t be known until we determine the amount of property taxes and the tax due dates with the County. We'll run through an example in a later section below.
Components Impacting Cash to Close:
- Initial Deposit: The lender may require a deposit to cover the first few months of property taxes and insurance. This deposit ensures the account has a cushion to cover any immediate payments due.
- Prepaid Expenses: Borrowers might need to prepay certain expenses, like property taxes already due or insurance premiums, at closing. These prepaid amounts go directly into the escrow account.
4. Benefits of Using a Lender Escrow Account
Advantages:
- Simplified Payments: Borrowers make a single monthly payment that includes their mortgage, property taxes, and insurance, simplifying the payment process.
- Peace of Mind: The lender manages the payments, ensuring that property taxes and insurance premiums are paid on time, reducing the risk of late fees or lapses in coverage.
- Budgeting Ease: Monthly payments into the escrow account spread out large annual expenses, making it easier for borrowers to budget.
Disadvantages:
- Higher Closing Costs: The need to pre-fund the escrow account increases the initial cash required to close the loan.
- Loss of Control: Borrowers have less control over their money, as the lender manages the payment of taxes and insurance.
- Potential for Overfunding: Lenders might overestimate the required funds, resulting in excess money being held in escrow, which could otherwise be used or invested by the borrower.
5. Why Are Lender Escrow Accounts Pre-Funded?
Escrow accounts are pre-funded to ensure that there are enough funds available to cover the property tax and insurance payments when they come due. This pre-funding acts as a buffer for both the lender and the borrower. Here is an example below.
Example 1:
Your loan is set to close on April 15th and your first payment is due on June 1st. The County Property tax bill is due in full August 1st. If the Lender didn’t Pre-Fund the Escrow account, they wouldn’t have collected enough monthly payments yet to cover the amount of the tax bill. In a case like this, the Lender would need to collect nearly the entire amount of taxes (12 months) at Closing.
Example 2:
Your loan is set to close on Jan 15th and your first payment is due on March 1st. The County Property tax bill is due in full Dec 1st. In a case like this, the Lender will have significant time to fund your Escrow account through each monthly payment they collect leading up to the Tax bill due date. They would likely only need to Pre-Fund a small portion (1-3 months) at Closing.
6. What's an Escrow Shortage or Surplus?
After your loan Closes and you begin making payments to the Servicer, you might eventually experience an Escrow shortage or surplus. An escrow shortage for a mortgage occurs when the funds in a homeowner's escrow account are insufficient to cover the expenses the account is designated to pay. These expenses typically include property taxes, homeowners insurance, and sometimes other property-related fees. A shortage or surplus usually happens for the following reasons.
Increase in Property Taxes: Property taxes may increase due to higher property assessments or changes in tax rates set by local governments.
Increase in Insurance Premiums: Homeowners insurance premiums can rise due to increased coverage costs, changes in risk assessments, or general rate hikes by the insurance company.
Initial Underestimation: When setting up the escrow account, the lender may have underestimated the amount needed to cover these expenses.
Payment Timing and Errors: There may be timing issues with payments or clerical errors that result in unexpected shortages.
Conclusion
Escrow accounts play a crucial role in managing the financial responsibilities associated with homeownership, particularly for those with mortgage loans. They ensure that property taxes and insurance premiums are paid on time, providing peace of mind and simplifying financial management for borrowers. However, they may require a relatively significant upfront investment and reduce the borrower’s control over their funds. Understanding the requirements, benefits, and implications of escrow accounts is essential for making informed decisions about mortgage financing and homeownership.