Real Estate Basics: What Is Escrow?

What is escrow? For real estate purposes, the term "escrow" signifies an account used to pay real estate taxes and hazard insurance. The charges are split into monthly installments and included in the borrower's mortgage payments along with principal and interest. Some mortgage lenders automatically add escrows to their policies, while others give borrowers a choice in the matter. Having an escrow on a mortgage has its advantages and disadvantages. Borrowers must decide for themselves whether the advantages make the escrows worthwhile.

Understanding Escrows

When a borrower takes out a mortgage loan, he or she will have to make monthly payments until the mortgage is fully repaid. Usually, the payment is made up of two parts—premium and interest. The premium is the portion of the mortgage the borrower is paying back, and the interest is the cost of maintaining the mortgage while the borrower is paying it back. Mortgage lenders may also attach various fees, but those tend to be smaller than either interest or premium.

Some mortgage lenders go a step further. They create escrow accounts to cover the costs of property taxes and hazard insurance. The property taxes are federal taxes that are levied against any piece of real estate within the U.S. borders. The hazard insurance is the insurance policy that provides coverage if the home is damaged or destroyed. The borrower pays the costs over the course of twelve months. The resulting funds are then used to pay property taxes and hazard insurance costs at the end of each tax year.

While some mortgage lenders will automatically include escrows in their mortgages, others will let borrowers choose whether they want an escrow. They are automatically required in all mortgage loans backed by the Federal Housing Administration (FHA).

How Escrow Payments Are Calculated

The escrow payments are calculated by taking all anticipated tax and insurance disbursements and dividing by twelve. Anticipated tax disbursements are calculated based on the property values at the beginning of each tax year, while anticipated hazard insurance disbursements are calculated based on insurance premiums. Since the real estate and insurance markets change constantly, those numbers have to be recalculated every year.

In some cases, mortgage lenders may have rules that require them to maintain the escrow account balance at a certain point. Usually, that point is no more than twice the value of the monthly property tax and hazard insurance payments. If the balance falls short, the mortgage lender may add extra charges onto the upcoming monthly mortgage bill to make up the difference.

Advantages of Escrows

Hazard insurance benefits both the lender and the borrower. For the borrower, the insurance helps to cover the costs of repairing the damage to his or her property. The lender benefits from the fact that if the home is completely destroyed, the hazard insurance will cover the portion of the mortgage the borrower hasn't paid back by this point. That way, the lender doesn't lose money.

While it is possible to obtain hazard insurance separately from the mortgage, escrow payments help the borrower save money. That's because the payments are split into twelve portions, making it easier for the borrower to make payments. Paying property taxes through an escrow account has the same advantage.

Disadvantages of Escrows

That said, the extra property taxes and hazard insurance payments do make the mortgage more expensive. The fact that the value of those payments changes from year to year introduces an element of unpredictability. After all, the borrower cannot be sure if he has to pay more or less during any given year. This makes it harder for the borrower to plan his or her budget and save money.

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