Escrow Accounts

Sep 25

Two Types of Escrow Accounts:

1) Earnest Money Holding - Closing Attorney/Settlement Agent / Title Agent account holds.

2) Lender Account - Ongoing Tax and Insurance Impounds

Earnest Money Holding

Escrow accounts hold earnest money deposits, showing the buyer’s intent to purchase the house. Additionally, while the funds are secured in the accounts, the seller can conduct required inspections, title checks, and other procedures.

This kind of escrow provides transparency and ensures the commitment of both parties to finalize the deal.

This system has several crucial benefits for all parties involved:

Security. Since assets are held by a neutral party, both the borrower’s and the lender’s interests are protected. The money will be released only after all obligations have been fulfilled. In the event that the deal falls through, the money is returned to the borrower, without any disputes.
Transparency. With an independent bank account, all transactions are documented and visible to all parties. It provides more control over the process and additional peace of mind during this usually stressful time.
Simplicity and convenience. After closing, the homeowner does not need to pay taxes and insurance separately. As these payments are included in mortgage payments, the lender can cover these expenses straight through the escrow account.

Ongoing Tax & Insurance Impounds

After the deal is closed, the escrow account, also called an impound account, is used to distribute ongoing payments such as property taxes and homeowners’ insurance. Part of the mortgage payments goes to this account, and the lender distributes these funds, ensuring that these essential payments are made on time.

Why Escrow Shortages Happen and How to Pre-Warn Clients

An escrow shortage is the risk that borrowers need to be aware of in advance. The shortage happens when the account balance is insufficient to cover expected payments, such as taxes or insurance.

The lender performs an annual escrow analysis comparing the predicted costs with actual expenses. The procedure helps to detect shortages and adapt the payments.

The most common reasons for shortages are:

Increases in local property taxes
Increases in homeowner insurance
Switching to another insurance policy
Missed mortgage payments
Underestimated costs at closing

Therefore, a shortage might happen due to the homeowner’s failure to make mortgage payments on time or for reasons beyond their control. So, the borrower needs to consider these risks and ideally have an additional budget to cover any unexpected expenses.

Opting Out: When & How to Request an Escrow Waiver

Until the mortgage is paid off, the lender is at risk of losing the money in case the homeowner skips tax or insurance payments. To mitigate these risks, lenders usually require opening an escrow account as it allows them to cover these costs on behalf of the homeowner.

However, in some cases, the borrower may be granted an escrow waiver which allows them to make the payments directly. Besides more control over finances, it allows the borrower to have less money on hand at closing and to place the money in an interest-generating account.

Guidelines for an Escrow Waiver

LTV limits. For conventional loans, lenders typically require a loan-to-value (LTV) ratio of 80% or lower. However, sometimes higher LTV might be acceptable when other conditions – such as low debt-to-income (DTI) ratio and high credit scores – are met.
State and loan program restrictions. Some programs (like FHA and USDA loans) require an escrow account so getting an escrow waiver isn’t allowed under any circumstances. For conventional and VA loans, waivers might be granted depending on the lender’s criteria.
Strong credit score. Typically, lenders require the borrower to have a 700+ credit score to be approved.
Clear mortgage payment history. Consistent on-time payments show that the borrower is financially responsible, so the lender’s risks of late payments are reduced.
Cash reserves. Sometimes, the borrower needs to show their cash balance proving they have enough money on hand to cover property tax and insurance directly.
Property type. Generally, escrow waivers are granted on primary residence and are rare for investment properties or secondary residences, due to higher risks.

Note that the lender might have flexible conditions, allowing exceptions for borrowers with strong financial profiles. Therefore, borrowers can apply for the escrow waiver even if not all requirements are met, and the lender will make a decision based on their own criteria.

Ideally, the borrower should apply for an escrow waiver when the loan is not finalized such as during the underwriting process or when filling out the loan application. If the borrower hasn’t applied before the closing, they can request it after one year of consistent on-time payments.

Other Factors To Consider:

1) Requesting an Escrow Waiver may impact the pricing offered. Some lenders charge .250bps in the pricing. If you wait until making the request post closing, you will avoid this fee. The loan servicer must accommodate your request, which is not a guarantee, but usually allowed if you meet the guidelines outlined above.

2) Theory - by paying the taxes and insurance on your own, you keep that money in your pocket throughout the year versus the lender meaning you could invest it, versus the lender making money off of your funds. BUT, you must be prepared to pay the bills when they are due. Not a surprise you want at Christmas time, for example.

3) Allowing you to waive escrows is an accommodation granted by lenders. They do not have to offer it and can change their stance at any time should they choose to do so.