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When you get a mortgage, the lender usually adds real estate taxes and insurance premiums to the monthly house payment. The lender sets aside this money in what is called an escrow account (sometimes it's called an impound account). An escrow account ensures that the taxes and insurance will be paid on time. This protects the lender from tax liens and uninsured losses that the borrower can't repay.
How escrow accounts are managed
The amount in the escrow account varies during the year due to tax assessments and insurance premium adjustments. The lender typically will cover any shortfalls until it can adjust your monthly payment to make up for tax hikes and premium increases. Your monthly mortgage payment will fluctuate from year to year, even on long-term fixed-rate loans.
Can I avoid escrow?
In some cases, you can avoid escrow. Some lenders allow you to pay your own property taxes and home insurance premiums, especially if your loan-to-value ratio is below 80%. But don't be surprised if the lender boosts your interest rate to compensate for the additional risk it is assuming.
Once an escrow requirement is in place, it can be difficult to persuade a lender to cancel it. If your loan is sold, as is common, and there is nothing in the lending agreement that provides for cancellation of the escrow requirement, you'll have to live with the decision of your new mortgage servicer.
Federal Housing Administration-insured mortgages require escrow accounts.
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Should you avoid escrow?
Should you set up an escrow account for a new home or shoulder the responsibility of paying taxes and homeowners insurance on your own? The simple answer: It depends.
"There's always a different reason for different people," says Adriana Mollica, Realtor with Keller Williams Realty Westside in Los Angeles. "The reality is, not everybody's equal."
Without an escrow account, you have to pay tax and insurance bills when they are due, and they often are large sums.
Here are some questions to consider if you're trying to determine whether to establish an escrow account.
1. Am I a good saver?
The first thing to ask yourself is whether you're a saver by nature. If not, you're better off having an escrow account, Mollica says. If money burns a hole in your pocket, it may be tempting to use the money you set aside for taxes and insurance and take a pricey vacation instead.
Pat Hellman, Wells Fargo's senior vice president of mortgage servicing operations in Des Moines, Iowa, says escrow accounts help homeowners with their budgeting as insurance and taxes fluctuate from year to year.
However, those who are self-employed or receive commissions -- thereby experiencing monthly income fluctuation -- have more flexibility if they pay for insurance and taxes directly, says Joe Chatham, who ran Chatham Mortgage Partners Inc. in Westlake Village, California, for many years. They can set aside extra money in months when their earnings are strong.
2. Where else can I put my cash?
If you're good at saving money, Mollica says it doesn't make sense to make monthly payments for something you need to pay only once or twice a year. "It's free money for the banks," Mollica says.
If you don't like handing your money over to the bank each month and are wary of the vagaries of the stock market, then savings, money market accounts and certificates of deposit could be alternatives. Even if the rates are low today, the rates will go higher in the long term, Mollica says.
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3. Will it make a difference with my bank?
Setting up an escrow account with your lender could result in you being offered a lower interest rate on your loan, which can bring substantial savings over the long haul, Chatham says.
But homebuyers also need to bring money to the closing table to fund the escrow account. Depending on the month you close and the month that the tax and insurance bills are due, it could add up to a hefty sum.
4. Whose responsibility is it?
If you have an escrow account, it's the lender's responsibility to pay all your tax bills in a timely fashion. Hellman says in some places, such as Texas, customers may have to pay separate tax bills to the county, school district, and water and sewer districts, rather than having them rolled together into one county tax bill.
The mortgage company must track down all the jurisdictions where your taxes must be paid. If the lender drops the ball and misses a payment, it's their responsibility to pay penalties, Hellman says.
While there are horror stories of lenders failing to make insurance and tax payments, Hellman says it rarely occurs.
But if you like the thought of controlling your own financial matters, it will fall on you entirely to make sure taxes and insurance are paid on time.
If you don't pay your insurance promptly, coverage could lapse, and that could result in your insurance company either charging you a higher amount or declining to renew your policy, Hellman says.
There also can be major problems if you forget to pay your taxes, says Chantay Bridges, a Realtor with TruLine Realty in Los Angeles. You could wind up with a tax lien on your home, and it will be impossible to sell your home until it's cleared up.
Not paying those items out of pocket means fewer payments you'll have to make and not having to worry they were received on time, Bridges says. Once you consider the pros and cons of each scenario, then you can decide what's right for you.
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