Lenders such as banks and mortgage companies require homeowners to set up escrow accounts to ensure that insurance premiums and taxes will be paid on time. An escrow account can seem confusing to new homebuyers and typically means additional money needed at closing.
Buying a home is one of the most important purchases an individual or couple can make but it is also one of the most expensive. The process of buying a home is filled with payments and topics that almost require a mortgage dictionary to wade through the process.
What is an escrow account?
Escrow is the name of the account that is set up to deposit money for taxes and insurance payments on behalf of the homeowner. It is a separate account outside of any mortgage lender’s general operating account.
What is included a mortgage payment?
A mortgage payment is the monthly payment made on a home. Mortgage payments will vary depending on different factors, but most mortgage payments are made up in part of principal, interest, insurance, and taxes. That is, the cost of insurance and taxes are generally included in a monthly mortgage payment. This is part of the escrow process.
What taxes could be included?
Taxes are a part of most homeowners’ financial responsibilities. Taxes will vary depending on state and local laws, and some may be required to be paid as part of the monthly mortgage. Common taxes could include:
- Property Taxes: These taxes are usually assessed by a county or city based on the value of a home and the land the home is on
- School Taxes: Many states or municipalities assess school taxes to support public education; some school taxes are built into property taxes.
- Utilities: Some municipalities or counties include certain utilities such as trash pick-up as part of the yearly cost of property taxes.
- Emergency Responders’ Tax: The taxes that pay for fire fighters and ambulance services can sometimes be included in property taxes or paid as a stand-alone tax.
What kinds of insurance payments could be part of a mortgage payment?
Home insurance protects the value of the home in the event of a fire, flood or other disaster. Many states have laws regarding insurance, as do mortgage lenders. Common insurance packages that might be required for a homeowner to carry can include:
- Homeowner’s Insurance: This insurance is generally a requirement unless a home is paid for in full and typically covers the cost of the home and its contents if destroyed or damaged from a fire, theft, or act of nature such as a tornado, falling tree or other covered peril. Homeowner’s insurance also usually covers the medical and legal costs if an individual is injured on the covered property.
- Private Mortgage Insurance (PMI): PMI insurance covers the risk of the mortgage payment not being made. It is generally required by lenders if a homebuyer cannot come up with a down payment that is at least 20% of the purchase price of the home.
- Flood Insurance: Depending on where you live you may be required to purchase flood insurance as flood damage is generally not part of homeowner’s insurance.
- Mortgage Insurance Protection: This could be a rider on a homeowner’s insurance that makes sure that the mortgage will be paid in the event of the sudden death of a homeowner.
How does an escrow account work?
Escrow is an account that is set up for homeowners to deposit money into at the closing of a house. The money deposited will go towards the taxes and insurance that will be paid as part of the monthly mortgage.
The lender usually requires an escrow account to ensure that the taxes will be paid on the home and the insurance against damage will remain current. This is to protect the lender from loss due to damage or destruction or forfeiture from a home seized for non-payment of taxes.
A homebuyer places a certain amount in the escrow account during the closing of a purchased home; this account will be used by the lender to pay the taxes and insurance. Then, a portion of the monthly mortgage payment is deposited into the escrow account for the payment of taxes and insurance. When the taxes or insurance payments are due, the lender pays them from the escrow account.
What would happen if the taxes or insurance were not paid?
The lender is at risk if a homeowner does not pay for insurance or taxes. A city or county could seize the home if the property taxes are not paid. The lender would either need to pay the taxes to reclaim the property or wait until it was sold at auction. Additionally, the lender would have to suffer a complete loss if the home burned down or was flooded and the insurance had lapsed.
Are there times when an escrow account is not necessary?
Requiring an escrow account is the choice of the lender, and it is usually installed when a homebuyer cannot afford 20% of the home’s cost as a down payment. This tells lenders that the homebuyer does not have a large volume of cash flow; thus, the homeowner is at a higher risk of not paying the taxes or insurance.
If a bank or a mortgage company feels that a homeowner has a low risk of missing the tax or insurance payments, then they might not require an escrow account. Making a down payment larger than 20% of a home’s purchase price is one way that can show a lender that an escrow account is not needed.
Any homeowner can request that an escrow account be done away with. However, if a lender agrees, it might be after a fee is assessed for waiving escrow.
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