What is an escrow account?
First, just what is an escrow account and why do you need it. An escrow account is an account set up when you open a mortgage that pays for all of the associated costs of home ownership. Your lender will take the estimated home owners insurance, property tax and mortgage insurance and add it all up. They will generally add a little additional cushion to this amount to try to account for discrepancies. They will then divide that amount by 12 to get your escrow payment. They then add this amount, your interest payment and principal payment to get your monthly mortgage amount.
The benefit to an escrow account is that you do not have to make all of these individual payments yourself. The mortgage servicer will handle all of the details for you. In addition, it breaks up large expenses, like property tax, into smaller and much more manageable chunks. Overall, an escrow account is a really good thing for a borrower.
Do I have to have an escrow account?
Yes and no. Most lenders will require an escrow account unless you have put at least 20% down on the loan. They are also usually required for government backed programs like USDA and FHA loans.
Most people will want to have an escrow account though. It takes all of the work out of the mortgage. If you did not have an escrow account, you will have to make monthly payments for homeowners insurance as well ad a lump sum payment for sales tax once a year.
The only real downside of having an escrow account is the fact that you are paying money in advance of bills due. If you have financial discipline you could be taking this money and investing it or at least earning interest on it from a bank.
What is an escrow shortage?
An escrow shortage occurs when you do not have enough money in your escrow account to cover the expenses. This can happen for a variety of reasons.
It is very common with new homes that have been built. This is because the initial property tax payment will be based on the land value of the property alone. After the new home has been appraised by the taxing authority, the value will go up and so will the property tax. The same thing can happen with existing homes as well, as property taxes increase every year with the increasing value of the home.
Essentially, any increasing bill related to your home that is paid by escrow could cause your escrow to go up.
The good news is that when there is a shortage, the bank will step in and pay it for you. This means that your property taxes will not be late and your homeowners insurance will continue to get paid. They also do this completely free of charge to you, there is no fee. So, as bad as it is for you to see a shortage, it is worse for the bank. They have to pay it with no financial reward.
How will you know that there is a shortage?
Once a year, your mortgage company will do an escrow analysis. If they determine that there is a shortage. they will send you a letter with the projected amount of the shortage and how much money you need to bring the escrow account up to date.
Who is to blame for an escrow shortage?
Not the bank, that is for sure. Although you might be angry that your payment is going up, the bank was not negligent and they are not trying to take advantage of you. When they set the escrow payment, they use the information that they have on hand to come up with as accurate of a payment as possible. This includes current insurance rates and property taxes. They do not have the ability to guess what your taxes will be in the future. If they did, there would be more conditions of escrow being too high and people being upset about having paid too much.
How do you fix an escrow shortage?
You have four main options when it comes to fixing an escrow shortage.
The first option is to do nothing. If you do nothing, the mortgage servicer will simply take the shortage and divide it by 12 months. They will then add that amount to your monthly payments.
The second option is to get your checkbook out and write a big check to pay for the shortage. This is easy enough if the shortage is 500 dollars but it is a bit tougher if your shortage is a few thousand.
A third option is to refinance the loan and have the shortage paid in the process. This might be a good option for you if you are paying a high interest rate and could also lower it with a refi.
Your fourth and final option is to cut expenses so that there is no longer a shortage. The easiest way that is to cut your home owners insurance cost. This can be accomplished by hunting for a better rate or perhaps raising your deductible.
How do you prevent an escrow shortage?
Your mortgage servicer is going to set your escrow amount but that does not mean that you have to stop with that amount. If you expect for their to be a shortage at the end of the year, you should pay a little extra towards your escrow with each payment. This is particularly true if you build or buy a new house. Both cases will typically lead to a large increase in the home value at the end of the year. A huge increase in value will mean a huge increase in property tax.