You and your spouse are in the market for your first home. You recently sat down with your realtor to talk budgets. They mentioned something about escrow, but it went way over your head. Do yourself a favor and do not blow off the idea of escrow in hopes of figuring it out later. It is going to play a key role in your eventual purchase decision.
The concept of escrow doesn’t apply only to housing. It is a principle you see in imports and exports, corporate finances, etc. Escrow is applied to real estate in order to account for insurance and property taxes. Simply put, lenders utilize escrow to make sure taxes and insurance are paid. It is in their best interests to do so.
How Escrow Works
Broadly speaking, the practical implementation of escrow involves collecting money from one party, temporarily holding it, and then using it to pay another. Online auction sites sometimes use escrow to protect buyers and sellers involved in international transactions. The site might collect payment from a buyer and hold onto it until the seller ships. Once proof of shipment is received, the site releases held funds to the seller.
In a real estate scenario, a lender will set up a separate escrow account through which it pays the borrower’s property taxes and homeowner’s insurance. That account is funded with money deducted from the borrower’s monthly mortgage payments.
Note that escrow accounts are funded in advance. The lender estimates what property insurance and taxes will cost for the coming year. They divide that amount by twelve and apply it to each of this year’s mortgage payments. If they estimate too high, you get a refund after next year’s bills are paid. If they estimate too low, they send you a bill for whatever amount is necessary to bring the escrow balance back to zero.
You Still Pay
The most important thing to understand about escrow is that you still pay your property taxes and insurance. Rather than paying for them directly, you pay your bank. They turn around and pay your insurance company and local taxing authority. And by the way, this only continues while you are paying back your mortgage.
Once your mortgage is satisfied in full, the lender is taken out of the equation. You then become responsible for directly paying property taxes and homeowner’s insurance. That means you continue having monthly housing expenses even when you are mortgage free.
Total Cost of Ownership
The realtors at CityHome Collective, a real estate brokerage in Salt Lake City, say the idea of escrow is important to understand because it contributes to the total cost of home ownership. They say that first-time buyers often don’t realize that a portion of their monthly mortgage payments will go into escrow.
CityHome Collective says that it is important to closely examine monthly mortgage statements to make sure escrow accounts are properly funded. Equally important are the lender’s year-end statements that shows taxes and insurance have been paid for.
Observant homeowners usually discover that their escrow payments gradually increase over time. That is because property taxes and the cost of homeowners insurance gradually go up. A larger portion of the monthly payment going to escrow means less money going toward principal. This is one of the reasons it’s a wise idea to make one or two extra principal payments every year if you can.
Mortgages and escrow accounts go hand-in-hand, like hot dogs and apple pie. Be sure you understand the escrow concept so that you can properly budget for a new home purchase.