Many people borrow money to make their home purchases. In that context, lenders sometimes set up “escrow” for real estate taxes, property insurance and private mortgage insurance (PMI).
Escrow literally means custody or control. An escrow account for a home purchase is a separate bank account into which a homeowner pays an equal monthly amount. The escrow account is in the custody or control of the lender, thus called escrow. The lender uses the money accumulated in the escrow account to pay for the irregular — usually twice per year — payments of real estate taxes and assessments. The escrow account may also be the source of funds for the payment of property insurance.
Lenders always worry about homeowners defaulting on their loans, which leads lenders to foreclose on the lenders’ mortgages. Lenders expect that the value of the property might be less than the purchase price at the time of the foreclosure. The rule of thumb is that it is reasonable for the property’s value to decrease by about 20% between the time of purchase and the time of foreclosure. Therefore, lenders usually require that borrowers make a down payment of at least 20% of the purchase price so that the lender will not be left short-handed if or when the lender forecloses on a mortgage.
Nevertheless, some homebuyers do not have a 20% down payment. In those instances, lenders will often make a loan to the homebuyer for more than 80% of the value of the home but require that the homeowner buy insurance from a separate company that will pay the up to 20% shortage if there is a foreclosure. This insurance is called private mortgage insurance or PMI, which is also paid from the escrow account.
Notably, PMI usually can be stopped when the outstanding loan amount is less than 80% of the value of the home. However, lenders’ software does not usually automatically remove the PMI until the loan amount to home value is about 78%. Therefore, it is always important for homeowners with PMI to check their loan amount relative to home value to see if the PMI can be discontinued before the lender software automatically discontinues requiring PMI. Sometimes, several thousand dollars can be saved by requesting the cessation of PMI before the lender software automatically stops requiring PMI.
Thus, escrow accounts charge homeowners a regular amount each month and handle the payment of real estate taxes and assessments, property insurance, and PMI.
Of course, lenders love having extra money in the escrow account, in an abundance of caution. Therefore, to prevent lenders from abusing the control to manage escrow accounts, there are federal rules concerning how many months of bills the escrow account can have “reserved” or on-hand. As a result, homeowners sometimes get a letter and a refund check if the escrow account reserves are too high. Similarly, if the escrow account gets too low, for instance due to increases in the amount of the items paid from escrow, the lender can increase the monthly escrow collection amount.
Lee R. Schroeder is an Ohio licensed attorney at Schroeder Law LLC in Putnam County. He limits his practice to business, real estate, estate planning and agriculture issues in northwest Ohio. He can be reached at [email protected] or at 419-659-2058. This article is not intended to serve as legal advice, and specific advice should be sought from the licensed attorney of your choice based upon the specific facts and circumstances that you face.