Pay into the Kitty: How Does Escrow Work?

When you finance your home, it’s very typical to see money set aside into an escrow account. What purpose does an escrow account serve, and do you have to have one?

When I explain escrow or prepaid items to my customers, I always liken it as to setting up a kitty. You know, like in poker. A place where your money sits until it’s decided where it should be paid. And if you’ve ever played poker, you keep adding to the kitty, till it gets passed out; then another kitty is created, and so on and so forth, until someone is broke or mad. Escrow for a mortgage is a very similar situation except hopefully we avoid the mad or broke part (particularly the broke part – that kind of talk makes a lender nervous).

What exactly is escrow? It’s part of your monthly payment that’s held by your mortgage servicer in an account (also known as “impounds” or “reserves”) so that your mortgage servicer can pay your homeowner’s insurance, taxes and, if applicable, mortgage insurance and flood insurance when the time is due. Some mortgage products or lenders require escrow. Sometimes, it’s not required or even allowed. It just depends on what type of loan you are getting.

Typically on a purchase, a lender will collect a 1-2 months portion of whatever your annual premium is for your homeowner’s insurance and put it into escrow. For instance, if your homeowner’s premium is $1000, the lender will ask for $200 in reserves. In addition, the lender will also collect the full $1000 premium to pay for your homeowner’s insurance until the next payment is due, a year from now. For taxes, lenders typically collect 4-5 months of reserves. One reason you always have more taxes collected then homeowner’s insurance is because all city and county entities usually want the tax bill paid in advance from when it is due. For instance, if taxes for 2008 are due in October, where do you get the money for November and December if you don’t collect it at closing? Further, if you had closed your loan in August, and the first payment isn’t due until October, you already had missed out on collecting escrow for 2 months if the borrower doesn’t make his payment until the last minute. You need that kitty to pay everyone when the time is due.

The other portion of escrow that is collected is per diem interest. This escrow portion collected is why most folks try to close on or about the last day of the month. The lender usually requires the borrower to pay the interest that accrues from the date of settlement to the first monthly payment. So, if you close July 28th, your lender will collect three days of “per diem” interest from July 29th to July 31st. Interest is collected in arrears, so your payment that is due September 1st will include the interest for the month of August.

The big thing to know about the prepaid section of a Good Faith Estimate is that you shouldn’t focus too much on this section when comparing lender’s costs. Whatever the lender reflects needs to be collected for escrow may vary a bit from lender to lender, but when you show up at the closing table, it just is what it is. The lender can’t control what the taxes are on the property, when the closing will be or how much you negotiate for homeowner’s insurance. Also, many times you can waive escrow, paying taxes and insurance out of your own pocket when the time is due. This luxury usually costs you a bit more out of your wallet. Think about where a lender would stand if you didn’t pay your tax bill or your mortgage. The tax man gets his money first. No big surprise, there, huh?


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Email your home loan financing questions to Kristin Abouelata, Home Loan Specialist with Mortgage Investors Group, at question@kristinmortgage.com or call direct: (865) 567-0113 Toll Free: 1-800-489-8910. For more information visit her website at www.kristinmortgage.com Home Loans Plain Talk.