Jack Guttentag, “The Mortgage Professor,” is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at MTGProfessor.com.
Mortgage lenders generally require borrowers to include taxes and insurance premiums in their monthly mortgage payments. The additional payments are placed in escrow until the payment dates when the amounts due are paid by the lender.
While mortgages are priced on the assumption that tax and insurance payments are escrowed, some borrowers can waive the requirement for a fee — usually 1/4 of a point, which amounts to $250 for each $100,000 of loan amount. To be eligible for an escrow waiver, the loan amount cannot exceed 80 percent of the lower of sale price and appraised value. An eligible borrower must take the initiative in waiving escrow. Waivers are not allowed on FHA mortgages under any circumstances.
With an escrow, the lender calculates the amount the borrower must pay each month as an addition to the mortgage payment. The borrower can check the calculation using the same HUD-defined procedure that the lender uses. (Note: the procedure is explained at How Do I Figure Escrows on my web site.) This additional payment goes into the borrower’s escrow account. The money in this account belongs to the borrower, though the lender usually keeps the interest on it. The lender is responsible for paying taxes and insurance out of the account.
Rationale for the escrow requirement
One rationale for the requirement is that it prevents a potential weakening in the protection provided to the lender by the property. If the homeowner is negligent for any reason and fails to pay the property tax, the tax authority could place a lien on the property that would have a higher priority than the lender’s lien. Similarly, if the insurance premium is not paid and the house burns down or is flooded away, the lender’s protection goes with it.
Since this rationale would apply to reverse mortgages as well as standard mortgages, an interesting question is why escrows are not required on the HECM reverse mortgage program.
My guess is that because there is no required monthly payment to add it to, policy-makers were reluctant to create a payment burden for elderly homeowners. This may have been a mistake.
Convenience versus control
For many borrowers, having the lender responsible for paying taxes and insurance out of the escrow account is a welcome convenience. When I had a mortgage, I viewed the escrow arrangement that way, because it simplified our budgeting and our life.
On the other hand, for “control freaks,” the escrow arrangement is an infringement on their personal autonomy. In support of the control freak, occasionally lenders muck it up. Their systems fail and the payments are not made. I have heard about a number of such cases from borrowers, some of them real horror stories. Yet such events are rare and when they happen the lenders responsible make the borrowers whole, although they don’t compensate them for their time, pain and suffering.
Loss of interest
When you establish an escrow account with the lender, in most states the lender gets to keep the interest earnings on the account. To calculate the interest loss, multiply the escrow account balance every month times 1/12 of the interest rate that you would receive if the account was yours rather than the lender’s. For example, if the account balance for December is $2,000 and your bank pays 2 percent on your account, your interest loss for December is $3.33 — 2,000 times .02 divided by 12. Sum the monthly figures to get the annual loss.
A few states require that lenders pay interest on escrow balances. If you are in one of them, subtract the rate you would receive on the escrow account from the rate you would earn on your own account. For example, if lenders must pay 1 percent, your loss in the example would be only 1 percent, amounting to $1.67.
Borrowers should keep in mind that in order to retain the interest earnings on their deposits, they must incur the upfront fee required to waive escrow.
If you don’t want to go through any of these calculations, don’t bother. Many borrowers take the path of least resistance by accepting the escrow arrangement, without trying to balance the financial pros and cons. To my mind, the key issue is how you feel about relinquishing, versus retaining control over one important segment of your personal finances.