When you get a mortgage to purchase, build or refinance a home, most lenders prefer to set up an escrow account so they can pay your property taxes and insurance premiums for you. A monthly payment is added to your mortgage bill and analyzed once a year to cover any increases in taxes or insurance premiums.
Actually, mortgage escrow is one of the most difficult aspects of loan servicing. There are many factors that make it hard for loan servicers to get it right, and for borrowers to understand what’s going on.Buying or building a home
Home buyers don’t always consider the taxes and insurance carefully enough, especially if they are moving to different state.Property Taxes
In many states, property taxes are reassessed the year after a home is purchased or built. This means that your property taxes may go up very significantly in the second year you own the home. When the lender sets up your initial escrow payment, the payment will be based on the property taxes of the previous owner. If you have had a house built, the initial escrow payment will be based on the taxes on the unimproved lot.Homeowner’s Insurance
The lender will have a much easier time figuring out how much to charge you monthly to cover homeowner’s insurance, since you will be required to obtain an insurance policy before you purchase the home or at the time your home construction is completed. If you are moving to a new state, it is very important to scope out homeowner’s insurance rates before you decide on the home purchase or construction. If you move from the Northeast to a state around the Gulf Coast, for example, your insurance costs can increase several times over. In some areas, homeowner’s insurance policies don’t cover hurricane or earthquake damage, and you will need to buy an additional policy to cover those perils.
Toward the end of the real estate run-up, I spoke to several troubled mortgage borrowers who had built investment homes in Florida, seeking to flip them for a quick profit. After several hurricanes, homeowner’s insurance premiums for unoccupied homes were very high and almost impossible to find in some areas. These borrowers were under tremendous pressure, as the insurance premiums were unaffordable and the homes were suddenly impossible to sell or rent-out.
Escrow Analysis and Trouble
Each year, the lender or loan servicer will send you an escrow analysis letter. This letter lists the escrow payments collected from you over the past year and the tax and insurance payments made by the servicer. It is when you receive the first or maybe the second escrow analysis that trouble can begin. Consider the following scenario:
You purchase a home in January 2006. Your initial homeowner’s insurance premium is paid by you at that time, and the bank then collects 1/12 of the insurance premium as part of your loan payment over the following year. Since property taxes are paid each November, The loan servicer collects a few months’ worth of tax payments at the beginning, and the rest over the course of the year. The loan servicer pays your 2006 property taxes in November 2006. Remember, the taxes for the first year are based on the previous owner’s taxes or the taxes on the unimproved lot.
So far so good. You are sent your first escrow analysis in January 2007. Let’s say that your homeowner’s insurance premium hasn’t increased. The property tax portion of your escrow payment is likely to be about the same, since the county has not yet reassessed the property taxes. So your loan payment stays about the same. The loan servicer doesn’t find out how much your reassessed taxes are until October 2007, and pays the higher amount in November 2007. When you receive your second escrow analysis in January 2008, be ready for a surprise!
For the sake of our example, let’s say the property taxes went up by $2,400. OK, that translates to $200 per month. Well, not really. You need to pay $2,400 more over the coming year, but what about the shortage of $2,400 for last year? That’s right. All things being equal, the loan servicer will increase your escrow payment by $400 per month.
What do you do now? For starters, call the loan servicer and ask to speak to a loan escrow specialist. You should be presented with a few options:
- If you can swing it, you might decide just to pay the extra $400 each month, knowing that shortage will be paid off over the next year, and your monthly escrow payment can be expected to go down roughly $200 the following year.
- You could pay cash for last year’s $2,400 shortage. This way, your monthly payment will increase by only $200.
- You can ask the loan servicer to spread last year’s $2,400 shortage over 24 months. Your escrow payment will increase by $300.
Granted, all these solutions for escrow shortage are painful, but it is best to call the loan servicer who can walk you through your options.Increases in Homeowner’s Insurance Premiums
I recently spoke to an acquaintance who told me that his mortgage payment had gone up $400. He has a fixed-rate loan, so the increase had nothing to do with any loan rate adjustment. I asked him if his homeowner’s insurance premium had increased, and he said he had discarded the mail from his insurance company because “the bank handles that.”
Actually his loan servicer, which happens to be his local bank, simply collects the escrow money and pays the homeowner’s insurance bill no matter how much it increases. In many states, homeowner’s insurance premiums can increase by huge amounts in just one year. Depending on the timing of the insurance premium payment and the loan servicer’s annual escrow calculation, the loan servicer may not realize the insurance premium increased by so much, and may not adjust the payment until the next analysis. This causes another “double whammy” payment increase.Steps you can take to reduce the risk of escrow payment shock
1. Before you buy a house, contact the county property appraiser and tax collector and come up with your own estimate of how much the property taxes will be after taxes are fully assessed. Also contact an insurance agent and get an estimate of how much your homeowner’s insurance premium will be. Add these together, divide by twelve, and add that to your projected loan principal and interest payment. (Assuming you have learned one of the painful lessons of the mortgage crisis and are getting a fixed-rate mortgage, you can use the sbup Fixed Mortgage Loan Calculator to calculate the loan payment.) Can you afford the combined principal, interest and escrow payment? Depending on whether you live in Hurricane Alley, can you afford it if your homeowner’s insurance premium rises 50%?
2. Find out how to contact your loan servicer. Call your loan servicer and ask when your annual escrow analysis takes place. Depending on the time of year you take your mortgage loan, consider changing the annual escrow analysis date, so that your payments can reflect insurance premium and tax increase more quickly
3. If you know your property taxes are going to increase the year after your purchase or construction, make sure you save up the money you will need to make up the shortfall. Remember, the lender or loan servicer probably won’t be collecting enough monthly escrow during the first year of the loan.
4. Even though the loan servicer will pay future premium bills, stay in contact with your insurance agent. Know when your annual homeowner’s insurance policy expires and find out how much the renewal premium will be. If the increase is too much, ask your agent to shop for a lower-priced policy, or visit some other agents yourself. You can check insurance company ratings using TheStreet.com’s Insurance Ratings Screener.