 Personal Finance PowerPoint Presentation. What's in your escrow balance and how can you track it? Get ready to get financially fit by practicing personal finance. Most of this information can be found at Investopedia, which you can check out online and continue with looking up the references, resources continuing your research from there. This is by Dan Miller, updated February 14th, 2022. Mortgages are typically made up of four parts, principal, interest, taxes, and insurance. So clearly when we're purchasing the home, we typically can't just put the cash down upfront for the purchase, typically need financing. We're gonna need to be picking up a loan. When we're paying off the loan, we're gonna be paying the principal and the interest. It's important for us to be breaking out the principal and the interest, which we'll show how to do in a bit more depth when we get into the practice problems, making amortization tables. And you might also have worked in there, the taxes and the insurance that you might be paying in a grouped kind of payment on a month by month type of basis. It's important to be able to separate those for different needs. However, obviously from a budgeting perspective, you might be able to consider the cash flow needs by grouping them all together. However, when you're looking at the taxation components of it, you wanna be breaking out the interest versus the principal and breaking out the taxes and insurance, which is something that at the end of the year might be provided to you on the 1098, breaking out that interest in the taxes and so on, on it. Together, these comprise so-called PITI, so you might hear the term PETA, P-I-T-I, which is the principal, interest, taxes and insurance. So often when you talk to financial institutions as to whether or not they believe you can make the loan payments and so on, and they're trying to do those types of calculations, you might hear this term because these are the things that are gonna be grouped in together to figure out whether or not you can make the payments. So we got the PETA and make up your monthly mortgage payment. Since taxes and insurance are typically paid annually or semi-annually, they are usually held in escrow by the lender or another company serving the loan. So these items, if you're trying to think about the month by month payment and they're gonna basically wrap this stuff up into one monthly payment, then you've got a couple issues, right? Well, the loan itself, we basically are going to tweak it so that it's an installment loan, which means we're gonna try to make the payments the same while the principal and interest will vary from payment to payment. The taxes and insurance also are usually not paid to where they're ultimately gonna go to. The taxes go into some kind of government entity and then the insurance, they're gonna be paid usually or semi-yearly or something like that. And therefore, if we're gonna kind of group them into our monthly payment, we're gonna have to estimate how much we're gonna need and divide it by 12 in essence and then combine that into the monthly payments that we're going to be making. That means that if we're making monthly payments, they're not always gonna line up exactly to how much we're paying out because we're only paying out on the taxes and insurance like once a year or twice a year and we're getting the money or the money's coming, we're gonna be paying the money on a monthly type of basis. So you pay into your escrow balance each month with your regular payment and your taxes and insurance are automatically paid from that account when they're due. What is an escrow balance? If your mortgage is escrowed, then your monthly payment is split into three parts. Two parts go toward principal and interest according to your loans amortization schedule. So we'll start to make the amortization schedules to get a feel for them in the practice problems. You also may want to, when you pick up the loan, get the amortization schedule from the financial institution or you can basically construct an amortization table from that point in time to get a feel for what's gonna happen over time because there's gonna be differences between the interest and the principal. In other words, by forcing the loan to be like an installment type of loan where the payments will be the same or uniform from month to month, we're actually sacrificing or we're gonna lose the ability to have the principal and interest portions be the same. Those will differ, those will have impacts on, that difference will have impacts on the equity calculations as well as the taxes possibly. So initially, most of your monthly payment covers interest. So when we're talking about the amortization table, because your loan balance is higher, the rent on the loan will be higher. So you're gonna be paying a lot more interest on the front end of the loan, even though the payment, the amount assigned to the payment of the loan is the same. Over time, more will be going towards principal. So towards the end of the loan, if it's a 30 year loan and you're down towards the end of that 30 years, most of what you're paying is now going towards principal or paying down the loan balance as opposed to interest because the loan is smaller and you're only paying for the rent in essence. That's what interest kind of is, renting the purchasing power, you're only paying for the renting of the purchasing power of the principal that's still left. That has a significant impact on taxes if the interest is deductible. So the third part of your payment goes towards your escrow balance. In many mortgages, funds are held in escrow to pay property taxes and homeowners insurance. So you might have that held in escrow to pay those other home needs, breaking those home needs basically down into a monthly component, even though they're not paid monthly in that case, kind of manipulating things a bit so that you're not having a bigger lump sum payment on the middle of the year or the end of the year, for example, and that can give some, this whole process gives possibly a little bit more of assurance on the lender side of things to make sure that you're able to pay these kind of things that also kind of makes them uniform on a monthly standpoint, which makes it easier for calculations and the budgeting type of things as well. When your taxes are insured, is due the company's servicing of the loan will take the money out of your escrow balance to pay those bills. So not all mortgages require an escrow account. So you may not be required to have this process to package them in there. If they're not, then you'll simply be paying off the loan, which will be the principal and interest payments. And then you'll be paying the property taxes and the insurance, if you have insurance, when it's gonna be required to pay them, which will be possibly semi-yearly or yearly, which would be a bigger cash flow that you'll have to budget for yourself when those things come up. Not all banks require you to escrow money for taxes and insurance. Federal Housing Administration, FHA loans require an escrow account. This protects banks' investments in your property by making sure that the taxes and insurance get paid. So in other words, they would kind of like to know from the banking side of things that the taxes and insurance are being paid because that makes them feel secure that you're still invested in the home because if you get backed up on taxes and insurance, then it's likely that you're not as invested in the home and it's the increased likelihood that it would be that you kind of like walk away from the home or something at that point in time. So they're gonna be feeling more comfortable if you're solidly invested, putting a down payment upfront, as much as you can get upfront, makes the bank feel better and better in the financial institution, as well as making sure all the related debts and costs to the home are up to date, such as the insurance and the property taxes. So you can escrow your taxes and insurance even if your lender doesn't require it. So they might not require it and you might still be able, you might still want to do it easier. And anyways, it could be more convenient in some ways because one, it makes it a monthly payment, makes it a little bit easier. And two, they might report that information for you on the W, the 1098, which might be a little bit easier for the reporting purposes for taxes as well. So, and they also might be if you're worried that you're not the best at budgeting and paying your bills on time or whatever and you don't want to make the property taxes or miss a property tax payment, then they might be better at just managing the property tax payments when they come due as well. This may simplify budgeting for these expenses. Obviously on the knot, they might have a fee for some of that process as well. And you also lose a little bit of the time value of the money because you have to hold it in the escrow account for them to then pay them when they're going to be due. So there's a bit of a trade-off on the pros and cons with that. Can I access money in my escrow balance? So if it's in the escrow balance, can I dip into that if I need it? Typically you can't access the money in your escrow balance. That money is held for the lender or loan service company on your bank, on your behalf. So you might be saying, hey, look, you've got money that you're holding onto in an account that's designated for me. But clearly the purpose of the whole account is that it's designated in that account to pay your specific bills related to the home in part not just for you but to make the lender feel comfortable. So typically you can't really just be like, ah, you know, I got some, I wanna go on vacation or something or I have a financial crisis more likely and I need to get the money out of the escrow balance. It's not what it's really designed for. In most cases, the bank doesn't pay interest on your escrow balance. So you might say, hey, if you're holding onto my escrow balance, you should be giving a return on it, meaning aren't you gonna invest in stocks and bonds? I can get a gain on stocks and bonds? No, because it's usually a short-term thing. They're not really gonna do that. If it's in a bank type of account, why don't you give me interest? Which these days, again, the interest rate is pretty low right now. So you might be saying at the point of this recording, but if we're currently in an inflationary period, it looks like so interest is gonna become more and more relevant, you know, as inflation, if in an inflationary period where rates are higher, interest will of course be more significant if you're thinking now, well, interest is fairly low. You know, I'm not making much on a bank account and interest, maybe not, but if the interest rates jumped up to some larger amount due to whatever economic circumstances, then of course, interest would be more important. And you might wanna be holding any money you have in a bank account that gives you some kind of interest in that environment, and typically the escrow account doesn't. So the total held in your escrow account is generally included in your monthly mortgage statement on your online account information. Periodic escrow analysis, the US government requires lenders to regularly analyze the amount of money in your escrow account. While most lenders do this annually, they may annualize your account more often if the amount that you owe for taxes and insurance changes. So in other words, it's possible that property taxes go up or insurance costs go up, which would mean that the amount that they're breaking down or estimating that you need to pay on a monthly basis could change. And if that happens, it's possible that you could have an adjustment to the amount that you would need to pay in that instance. So during escrow analysis, the lender calculates the amounts that will come due for property taxes and homeowners insurance in the coming year. As an example, say the upcoming year looks like this, January 2500 in semi-annual property taxes, April 1000 for hazard insurance, July 2500 for the second half of the property taxes. So with 6000 in your expected yearly outlay coming up, the lender will divide that by 12 to get a 500 monthly payment towards your escrow account. So they're gonna annualize what they gotta pay. Clearly what they're gonna be paying out is not happening on a monthly basis. They're projecting what the yearly costs will be dividing it by 12. That's the amount that they're gonna be charging you. So when we pay into the account then on a monthly basis, they're gonna be holding onto the money until the money is gonna be due, which isn't due on a monthly basis, right? So then government regulations also allow escrow companies to maintain an extra amount in your account as a cushion in case unexpected payments arise. So you might say, well, that's kinda cutting it close maybe we should have a little bit more money in there just in the event that added costs come up and we don't wanna be short to not pay our bills in there so we could have more money involved as a cushion. And that would of course make them typically more comfortable because to be able to pay the bills up that are coming up. So depending on your escrow balance, your monthly payments may be slightly more than the total expenses divided by 12. So they might say, okay, I'm gonna take that total amount divided by 12, but we're gonna account for a little bit of a cushion in the event that it's necessary for one reason or another just for a safeguard possibly. When your lender performs the escrow analysis, they will send you a statement either by mail or in your online account. This statement will detail the results of the escrow analysis and your new monthly payment amount. The bottom line, your escrow balance is the amount of the money that is held for you in your escrow account also called an impound account in some areas of the country. You pay into your escrow account each month as part of your regular mortgage payment. Not all lenders require an escrow account though many do. Even if your lender doesn't require it, many people prefer having an escrow account since it makes budgeting for these expenses easier. Why does it do that? Because it takes these payments that are usually annual and puts them into a monthly payment. So if you're not as good, so the pros and cons on the budgeting would be, you might wanna have the cash flow and pay it as late as possible. That's usually good cash management which means you wouldn't want it in the escrow account. You wanna pay it when it becomes due. But on the other hand, you might be saying, I don't wanna worry about it. I wanna have it as even as possible monthly expenses. So I'll let the escrow company and do it on a month by month basis possibly and also lowers the likelihood that you missed the bill because it doesn't come on a monthly basis. Maybe you're worried that you're gonna miss it and that's gonna cause you problems and so on and so forth. So maybe if you just pay it all on a monthly basis and you can make that kind of automatic, that might be a more easy thing to do and worthwhile just from a logistic standpoint as well.