As a homeowner, you are required to pay property taxes, homeowner’s insurance (a/k/a hazard insurance) and flood insurance (if you are in a FEMA designated flood zone). Lenders give borrowers the option to pay 1/12 of the annual tax amount and/or insurance premium monthly with the mortgage payment. These funds can get set aside in an “escrow” account and will be used to pay the taxes and insurance once they are due. Lenders typically give borrowers the option to escrow both taxes and insurance, only taxes, only insurance or to waive escrows.
Here’s an example - if your principal and and interest payment is $1,000, your annual taxes are $6,000 and your annual homeowner’s insurance is $600; your total payment per month would be: ($6,000/12) + ($600/12) + $1000 or $1,550 principal, interest, taxes and insurance (PITI). The escrow balance that accrued over X months would be used to pay the taxes and insurance on their respective due dates.
Advantages of Escrowing:
Allows you to set aside a little each month, rather than coming up with one lump sum.
The lender pays the taxing authority and insurance company(ies) directly and on time.
Disadvantages of Escrowing:
You need to set up the escrow account when you purchase or refinance and this can either increase the total loan amount or increase the funds required to close.
You could be earning interest or returns on your money, rather than it sitting in escrow.
If you have variable income, e.g. commissions, bonuses or you’re self-employed, you may want to keep your required monthly payment as low as possible and worry about paying the taxes and insurance when you receive more income.
When Property Tax and Homeowner’s Insurance Escrows Are Required:
Conventional loans: you typically need at least 20% equity in the property to waive escrows, however, there are lenders who will waive escrows with 10% equity*.
FHA loans: require escrows regardless of the amount of equity in the property.
VA loans: the VA does not require escrows per policy, however, the VA puts the responsibility of paying the taxes and insurance on the lender and there are few lenders who will allow escrow waiver, regardless of the amount of equity in the property.
USDA loans: unless your loan is <=$15K, you will be required to escrow regardless of the amount of equity in the property.
*There are countless sites that incorrectly state that Fannie Mae and Freddie Mac, who dictate the underwriting guidelines of the vast majority of conventional loans, require escrows on all loans over 80% and charge a fee, or an LLPA (loan level pricing adjustment to the rate) if you waive escrows. This is not true. A standard mortgage issued by either Fannie or Freddie states in section #3 of their uniform mortgage, “Borrower shall pay the lender the funds for escrow items unless lender waives borrower’s obligation to pay the funds for any or all escrow items.” The ability to waive escrows is solely at the discretion of the lender, and not Fannie or Freddie. Fannie and Freddie do not charge fees or LLPAs for escrow waivers, the lender does. Why this is important, is because you can find a lender that will allow you to waive escrows with only 10% equity and not necessarily charge an escrow waiver fee on a conventional loan.
Flood insurance must always be escrowed. Any time the property is determined to be in a special flood hazard area (FEMA flood zones A or V), flood insurance is required by federal law. The federal government requires that flood insurance must be escrowed with no exceptions.
If delinquent property taxes are being paid off in a refinance transaction, you will be required to escrow taxes regardless of the amount of equity in the property.
Escrow Waiver Fees and Risks Associated with Escrow Waiver:
Additional risk is introduced when escrows are waived and this can come at a cost. Some lenders will charge an escrow waiver fee. This fee is typically 0.25% of the loan amount. This can be paid as an upfront fee at closing or you can take a slightly higher rate to cover the cost of the fee. Typically, it is advisable to pay the fee upfront, unless you plan on paying off the loan in a relatively short amount of time.
The majority of the risk is specific to the property taxes. Property taxes that are in default are considered “priority liens.” Priority liens can take the first lien position ahead of a mortgage without the written consent, or subordination agreement from the lender who is currently in the first lien position. Once the defaulted taxes move into the first lien position, the taxing authority can now foreclose on the property to pay the taxes that are due. The tax foreclosure process can ultimately result in the lender not recouping the full unpaid principal balance, because the delinquent taxes will be paid in full, prior to the lender receiving any funds from the sale of the property, that was more than likely sold at a discount to expedite the sale. Here’s an interesting overview of tax foreclosure process in New Jersey.
Revoking The Waiver:
Lenders reserve the right to revoke a borrower’s escrow waiver, i.e., demand escrow payments. This is applicable if the taxes or insurance become delinquent.
Keep in mind that the property taxes will most likely increase each year. This will result in an escrow deficit because the amount of the monthly escrows was determined based on the previous tax bill. You will need to either pay the deficit in full or the lender will allow you to pay it over the next 12 months. This can also be applicable to insurance premiums.
What Cannot Be Escrowed:
Homeowners’ association dues, master/blanket insurance policies that cover condos or PUDs (planned urban developments, e.g. townhomes or gated single-family residence communities), and co-op maintenance dues (which include the property taxes and blanket insurance policy for the building).
The Bottom Line:
I often get asked what I do personally, as someone in the industry for 20 years. Personally, I waive escrows, but that doesn’t necessarily mean you should too. You need to assess your overall situation and discuss options with your loan officer, including, but not limited to the potential costs associated with waiving escrows. Click here to set up a mutually convenient time to have a discussion with me to figure out what works best for you.