 Personal Finance PowerPoint Presentation. What to know about your escrow balance. Get ready to get financially fit by practicing personal finance. Remember that most financial decisions can be broken down into the short-term and long-term financial decisions. The short-term decisions being those that we're going to train our gut in order to trust our gut. We're going to hone down our habits so we can depend more on them to make those short-term decisions. Long-term decisions being ones where we're going to follow the adage of measure twice and cut once. We don't have the same capacity to use the trial and error for the longer-term decisions. We want to put in place a more formal process. So we're going to think about the home purchase, which of course falls into the longer-term decisions. And we can break that out into five categories. Number one, determine the home ownership need. Number two, find and evaluate a property to purchase. Number three, price the property. Number four, obtain financing. And number five, close the purchase transaction. What to know about your escrow balance. Most of this information can be found on Investopedia, which you can find online. Go in there to take a look at the references, resources and continue your research from there. This is by Andrew Martins, updated February 21st, 2022. Home ownership is saddled with a lot of financial terms that may end up sounding like another language to the average person. Sign on the dotted line of a fixed-rate or adjustable-rate mortgage and you're immediately responsible for paying back its principal by the end of its 15 or 30-year term, all while keeping its annual percentage rate, the APR, and amortization in mind. So most of us don't have a lot of experience with financing on the personal side of things. And if we do, it's usually for smaller dollar amounts, possibly financing for something like a car. When we move on to the home, the financing that we're taking on is typically going to be a lot longer. It's typically going to be covering a longer time frame. So there's a lot more kind of on the line. And then of course just going through the process is going to take some time as well, more time than typically other types of financing that we may have experienced. So one term that you're also likely to hear a lot in the pursuit of your next home is quote escrow. While that term has multiple meanings, depending on the context, the escrow associated with your mortgage is an important tool that you should know more about. Below are some of its less commonly known factors and features of a mortgage escrow. What is a mortgage escrow account? You might ask designed to protect against fraud, non payment or some other form of financial malfeasance. An escrow account provides some peace of mind to all parties involved in a transaction as a concept. Nearly every type of escrow account can be defined as a tool by which both parties of a transaction agree to let a third party hold on to assets or funds during a transaction. So basically you got a longer term kind of transaction in this case with the home purchasing process. You would like to go through some verification process as you kind of seal the deal. And as you do that, it would be nice if you could have a third party, which you can trust the third party to be holding on to the assets during that time during that verification process. So once the transaction is complete, the escrow is dispersed to the receiving parties. So you can kind of think of the escrow possibly as like a third party type of holding account that is going to be hopefully a trusted area that can hold on to the items fourth until the transaction has been complete. So it's kind of like a clearing account. We're going to go into the escrow and then the escrow is going to be completely taken out. You could think if you think of it like a kind of similar to a bank account, you could think about money going into kind of a bank account just for a holding a short period of time. And then it's going to all be basically dispersed back out to the various places it needs to go once everything has been settled. And the case of real estate transaction and escrow account can be used either during the initial home buying process or in the case of a mortgage escrow after the property is closed upon. Lenders often require at the time of closing that you deposit two months worth of estimated property taxes, mortgage insurance fees and homeowners insurance fees into your escrow account as part of your closing costs. Typically, a mortgage escrow account is required if you attempt to purchase a home with a down payment of less than 20%. That's because such a low down payment makes lenders worried about your credit worthiness. In their eyes, you'll be more likely to miss property tax payments or fail to attain homeowners insurance, making you a higher risk than other borrowers. So remember from the lender's perspective that down payment is going to do a couple things to make them feel more secure. One, it's going to make sure that you're actually invested in the property. If you didn't put any money down and you put or you put less money down the less money that you put down, it's more likely that you might say, I'm just going to walk away from this financial transaction, right? Especially if the market goes down, if the market went down and the value of your home was less than the loan that you had that would lead people to more likely kind of just walk away from the home. So if you put the money down, then you're going to be invested in the home. And then also the lender is going to feel more secure in the event that you default on it because they're more likely to be able to foreclose on the home and then sell the home for an amount that's going to be higher than the loan balance. If you didn't have that cushion between the value of the home and the loan balance, then if there's an event where the value of the home goes down or even if it stays constant, they still have to pay for basically the process of selling the home in the event of a default, which they don't really want to do, of course. So this long-term escrow account, which is sometimes called an impound account, is used to cover a variety of monthly costs that exist on top of your mortgage payments. Rather than having to save up for each of those payments, the mortgage lender calculates the yearly cost of each fee that the escrow covers and divides it up into a monthly amount. The result of that calculation is then added to your monthly mortgage payment and automatically deposited into the escrow account. It should be noted, however, that the monthly escrow payment isn't considered part of the mortgage itself. So in this case, if they're kind of packaging the taxes involved in it together, it's possible that wherever you're at that's charging you the property taxes might only charge you the property taxes like twice a year or something like that. If they're going to basically bundle it in to the payments that are going to be made, then they're going to try to accrue it or divide it out evenly over the year so that you have those payments along with your mortgage payments. But you got to make sure that you keep those two things separate because they're going to have different tax implications. For example, part of the payments that are being made going to the actual loan, which has interest and principal involved in it. And then if any other payments are being made during that process, it's going to be going to something else like the property taxes that hopefully will be broken out for at least tax purposes at the end of the year on the form 1098, breaking out the interest component and the amount that's going to property taxes, hopefully. What fees are covered by a mortgage escrow? From the outset, a mortgage escrow is meant to simplify the home ownership process as it relates to your monthly costs. By keeping a consistent balance in escrow each month, your escrow agent can cover various unavoidable fees and taxes. Though they don't cover every monthly charge that you'll experience as a homeowner, mortgage escrows cover some very important ones. Property taxes. Unless you qualify for an exemption, your property taxes are an unavoidable cost of home ownership in America. So clearly when you purchase the home, property taxes are going to be one of the things that you're going to have to take into consideration. Property taxes are going to vary from place to place depending on where you purchase the home. But you want to make sure that you've budgeted for the property tax in some way, some shape, some form. Based on the assets value of your property and the municipal tax rate, property taxes help pay for local programs and services. Each mortgage payment will include one-twelfth of your yearly property tax bill. So if it goes through this process and it's included in essence in your mortgage payment, then what they're going to try to do, note that the property taxes might be paid like every six months or once it depends on where you are at, because it could change depending on where you're at, but it's not oftentimes going to be a monthly kind of cost. But they're going to try to break it down to a monthly cost if you're using this process to pay the property tax. And that can help with like a budgeting type of thing because then your monthly expenses will be kind of the same in that instance. So insurance fees, insurance helps protect your investment so your mortgage lender will do what they can to ensure that your property is insured. So insurance is typically going to be one of those things that's going to make the lender feel more secure as well. So a mortgage escrow specifically covers homeowners insurance as well as other hazard insurance needed. For instance, if your property is located in an area that regularly deals with wildfires, your mortgage escrow will likely cover fire insurance fees. So why is this important to your lender? You might ask, well, obviously they want the home is going to be support to you defaulting on the loan. In other words, it's the recourse if you default on the loan. Obviously if the home burns down, then they're not going to have the recourse when you can't pay the mortgage. If your home burnt down, you might not be able to afford the mortgage payments or might not feel very incentive to pay them. Those mortgage payments at that point in time and the bank won't be able to go after the home because it burnt down so it won't have the same value. And so that's why it's going to be an important component to the lender. So once again, the yearly costs for your ongoing premiums will be divided by 12 to cover each calendar month, even though the escrow account usually pays for the insurance company twice a year. Mortgage insurance fees, unlike the other mortgage fees that your escrow will cover, mortgage insurance is more for the lender's peace of mind. According to the Consumer Financial Protection Bureau, the CFPB mortgage insurance is usually required when offering less than 20% as a down payment. As previously mentioned, offering such a low down payment makes you seem like a high risk borrower. So remember that the bank is always trying to balance out the risk versus reward. And in investment, they want to give you the investment because they want to earn the interest which you're going to be paying them over a long period of time. But they got to balance that out over the fact or over the fact that it's possible that things can happen that result in you not being paying them back and they got to measure that risk. So they're measuring the risk versus the income that they're going to have. And the down payment is going to be a significant impact, a significant factor like we talked about before. By taking out mortgage insurance, it protects the lender if you fall behind on your payments and lose the property through foreclosure. So fees that a mortgage escrow doesn't cover non-property tax fees, aside from your property taxes, you're on your own. Supplemental or interim tax bills that may pop up following charges to the property or any other additional taxes levied by the state, county or municipality are outside the mortgage escrow's purview. Homeowners association dues, so this would be dependent upon where you are in if you have to pay the homeowners association dues. Whether you love them or hate them, if you live in an area with a homeowners association, the HOA, then any associated HOA fees are yours to handle. So you've got to put that into your budget. Failing to make these payments can result in additional late fees and even litigation. So it would behoove you to stay on top of them. Fees from non-essential insurance policies. Any additional insurance policies that you may take out on the property that the mortgage lender deems non-essential will be your responsibility as well. There are plenty of insurance policies that you don't actually need. So be sure to stay away from them if you want to pay only for the premiums that your mortgage escrow covers. Does an escrow accumulate interest? So you might be saying, hey, look, if my money is in this holding account, you're holding on to it until you're going to be using it. Shouldn't I be making money on it in some way? And the one way you might say, well, can't you invest it in stocks and bonds or something like that? And typically there the answer is no, because that will usually increase the level of risk that would be involved. And it's usually more of a short term type of thing. The other thing you might ask is wouldn't I get interest on it? Now at this point in time, interest rates are still pretty low at the time of this recording. The inflation seems to be going up. If you're in an inflationary period where interest rates are higher, then of course it would be a more significant question that you'd be saying, hey, I'd like to be earning some interest on my money that's in the bank account. In nearly every case, mortgage escrows are not held in interest bearing accounts, though Congress made multiple attempts in the 1990s to require that interest be paid by the lender on mortgage escrow accounts. None was ever signed into law. That being said, lenders are required to make interest payments in Alaska, California, Connecticut, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New York, Oregon, Rhode Island, Utah, Vermont, and Wisconsin. Those interest payments are usually required to be paid directly to the customer, though there may be some exceptions to that rule. What happens during an escrow shortfall shortage? Since your mortgage escrow is based on taxes and insurance premiums, it's likely that costs will increase at some point. So if costs increase, what's going to happen with this whole process of the holding account? So if such charges occur and your monthly escrow payments are unlikely to cover the difference, then you may be projected to fall into an escrow shortfall or escrow shortage. So the holding account is looking like it's going to need more money in it at that point in time. So an escrow shortage occurs when either your costs are more than the anticipated or estimated costs for the next year show that your current monthly rate won't be enough. If your escrow balance actually falls below an acceptable level, then it's very likely that your lender will automatically adjust the monthly payment accordingly. So that's what you would expect to happen if there's an increase in the property taxes and so on. And all of a sudden, what you were paying before is not covering it and your account is going to go below the threshold, then we'll have to adjust the payments. So this means that you will likely have to contend with a larger monthly mortgage payment that will remain in effect even after the shortage is ameliorated. So clearly in that case, they're going to increase it when they say it's a mortgage payment. It might not be because your mortgage changed in that case, meaning the amount that's going towards the payment for your actual loan isn't the factor here. It could be other things, possibly the property taxes, for example, that went up and they're kind of grouping that together with your total payments. Can you put extra funding into the escrow balance? You don't have to wait for a potential shortfall or shortage to increase your monthly mortgage escrow payments. So you might be able to preemptively see that there could be a problem in possibly fund the account. You might ask, you say, well, could I fund the account in some other way before there's any adjustments to the monthly payment? So most lenders will happily accept as extra funds as a cushion of sorts as long as you specify that the money is for the escrow account. Any excess money left in the escrow account is likely to be refunded to you at the end of the year. So you lose nothing as long as you can afford to set aside the money in escrow. So obviously if it's in the holding account and you have a little bit more cushion to pay off any of the necessary fees that come into place, that should make them feel happier about the situation. If it's still your money, it's just going to be in this holding account. What do you lose from doing that? Well, that means you can't put the money elsewhere. You can't spend it and you're not making interest on it or making, you know, you could invest it in dividends and gains or whatnot. So you may want to make a larger escrow payment if you know that next year's taxes and fees will be higher and that you want to pay the difference in one lump sum rather than spreading them out over 12 months of higher rates. So that could make you feel a little bit better. You might be able to say, hey, look, I can see that the costs are going up. I'd like to just pay for it right now because I happen to have the money and I want to keep my payments then the same. Instead of having you increase my monthly payments, for example. Remember, however, that any money you deposit in your escrow account is money that's not being used to pay down the mortgage itself. Convert your increased home equity. So that's the other thing you could do with the money, right? If you have the extra money, a couple of things you could do. You could invest it, right? And then you would invest it if you could get a rate of return that you think might be higher than what you're paying in terms of the interest rate. Or you could, of course, pay down the mortgage itself with that money rather than putting it into that holding account. You could pay down the actual, and that would mean the principal balance of the loan would go down, which is great because you'd be paying less interest if you could pay down the principal of the loan generally. So those are usually kind of the options you're thinking of. I got some excess money. I might be able to put it into stocks and bonds possibly and get a rate of return higher than the interest I'm paying, for example. Or possibly I can pay off the debt if I have the ability to pay it off early. Then paying off the debt would be great because I can lower the amount of the principal there more quickly, which would lower the interest that I would be paying.