An escrow account, or impound account, is an account that your lender sets up in order to collect homeownership-related expenses like property taxes and insurance before they’re actually due. Once a year, your lender estimates how much your annual tax and insurance bills will be. It then spreads the cost out so that you pay a bit every month rather than all at once.
There is another, more straightforward type of escrow account used at closing. If the sale is all but finalized, but for a few additional conditions, you may hand the cash to close to a third party to ensure you won’t back out unexpectedly. For example, if you agree to let the seller stay an extra week in the house, you may put the cash in escrow to provide reassurance.
There are advantages and disadvantages to the sort of impound account that extends beyond closing, but they primarily boil down to one question: Would you sacrifice a little freedom for a little security? If you can responsibly manage your finances, forgoing an escrow account lets you invest your money or respond to emergencies. But if you’re somewhat spendthrift, the imposed discipline of escrow could be just what you need to keep your home.
Who is required to have an escrow account?
Typically, Federal Housing Authority loans require escrow for the full term. Private mortgage lenders may also require an escrow account to ensure you have enough money to pay your property taxes and insurance, particularly if they consider you a riskier customer. This is to protect their investment in your property. If you fail to pay your taxes and the government places a lien on the property it can put the lender at risk. Even after you’ve signed the mortgage, if you suddenly become delinquent in paying your property taxes or insurance the lender may add an escrow account to your loan.
You may be able to close your escrow account once you have built up enough equity in your home. If this is something that you’d like to do, ask the provider when it would be permitted.
What are the downsides of escrow accounts?
Less flexibility. If you run into a short-term cash flow problem the month after taxes are due, you’ll still have to pay the prorated tax amounts into your escrow account. Eschewing impound accounts would allow you that extra wiggle room.
Return on savings. The escrow money might be placed in a low- or no-interest deposit account, meaning you’re giving up the potential returns of investing the money yourself. For example, if your annual tax bill is $12,000 and your return on investment is 4%, you’re giving up over $200 compared to investing $1,000 a month and paying $12,000 at once.
Why should you consider an escrow account?
Even though your lender may not require an escrow account from you, you may want to open one voluntarily. Knowing how much you’ll have to pay each month keeps you from being unpleasantly surprised on tax day. If you haven’t budgeted enough, you can face fines, penalties or high-interest loans.
Bottom line: Escrow accounts are budgeting aids. If you’re on top of your finances, you’re probably better off without them. But if you struggle to make large and infrequent payments, they can be a source of support – and of course, sometimes you aren’t given the opportunity to opt out.