Mortgage Escrow Explained - Do You Need It?

Certified Mortgage Advisor
NMLS 1701021
Published 
February 9, 2020

Questions that need answers about escrow

Now let's talk about mortgage escrow. So what is mortgage escrow? Should you escrow your payments? And what does the whole thing look like?

What is in mortgage payment?

So when we're talking about a mortgage payment, we're really talking about four separate things that are making up the entire payment. So it's going to be principal, interest, taxes, and insurance.

Principal

So principal is simply you paying back the amount that you borrowed.

Interest

Interest is the cost of being able to borrow that money.

Taxes

Taxes of the county property taxes that you'll be paying.

Insurance

Insurance is mortgage insurance. If you're putting less than 20% down. Then homeowners insurance to protect your house in the event of damage.

PITI

So that makes up principal interest taxes, and insurance, the PITI, or otherwise known as the pity payment. So that's the total payment, normally that you'll see requested from the lender every single month after you close on a house.

How it works

It's a little bit different. So we have the principal and interest payment are paid monthly to the lender or the bank, but the taxes and insurance are different in that they're paid monthly, but they don't go directly to the county or directly to the insurance company. Instead, what happens is we're paying the taxes and insurance monthly, but those go into what's called an escrow account.

Escrow Account

An escrow account, I think the best way to think of it is like a savings account. So it is an account set up by the lender on your behalf to make sure that taxes and insurance are always paid.

This is why it's set up this way is because taxes, at least in this part of Ohio are paid semi-annually. They're paid in February and July. So instead of having the burden of saying, we have to save up for February's tax payment and July is tax payment and make sure that we're always ready to pay those. Instead, the lender will say, Hey, we'll prorate what that tax bill is going to look like into monthly installments. You put it into a savings account and we'll pay it for you.

How it works for insurance?

And they do the same thing with insurance. Since insurance is paid as an annual premium or it's paid upfront for the first 12 months, you put money into the account every single month. And then when the bill comes due, the lender will pay that insurance on your behalf.

So when you close on the house, you set up the escrow account. To set up the escrow account, the lender will require that you put in a couple of months of homeowners, and a couple of months' worth of taxes into the escrow account to make sure that there is a cushion for when those bills are due.

Setting up an Escrow Account

So you set up the escrow account, the lender will show you how much money needs to be put in the escrow account. Then every single month you'll be paying in the taxes in the insurance, and then when those bills come due, you don't have to worry about paying for them because the lender will then when the bill comes due, pay it out of that escrow account, or you can think of it as a savings account that the lender will use it for you.

Should you escrow?

Before we talk about if you should escrow or not, most of the time you have to put 20% down to waive the escrows. The reason for that is it's a little bit riskier to waive escrow because now you're responsible for making those tax payments and the insurance payment.

So when those bills come do it, you have to pay them. Otherwise, you risk the penalty of not paying taxes and not paying insurance. So most of the time it's going to require 20% down. Now we do have an investor that we work with that only requires 5% down and there's no escrow fee or no escrow waiver fee. So something to consider.

Benefit of mortgage escrow

But if you are escrowing, the benefit is that it's really easy. You don't have to worry about paying taxes and insurance, but the downside of escrowing is that you have to set up that account, which could be a couple of thousand dollars worth of taxes and insurance set up in the escrow account.

That's somebody else managing your money for you, which if you like that, great, it makes it really easy. You don't have to worry about that.

Waived Escrow responsibility

But on the other end, if you wave escrow, you're responsible for making the payments in you're responsible for paying the tax bill and the entrance bill, but you don't have to set up the escrow account. So that's an extra couple of grand that might be in your pocket that you could use for other investments or other expenses and spending just keep in mind, you have to make those bills when they're due.

So that's the gist of how escrow works. It really is just taking these bills that are due on a semi-annual or an annual basis, and prorating that them down into monthly amounts, setting them into accounts so that you always have that money when the bill is due.

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