The Pros and Cons of Escrow Accounts

Have you ever seen those visual puzzles where, depending on whether you focus on the figure or the background, the image looks like a vase or two silhouettes, a feathered hat or an old woman? Escrow accounts are similar -- how you see them depends largely on where you focus.

An escrow account, also called an impound account, is an account the lender uses to pay the borrower’s non-mortgage related property ownership expenses. The big expense covered by escrow accounts is property taxes, but they can also be used to pay homeowner’s insurance and homeowner’s association dues. At close of escrow, the borrower usually prepays a couple of months’ worth of taxes and insurance into the impound account; thereafter, the taxes,  insurance  and other costs are rolled into the mortgage payment and the lender breaks the single payment up and directs it to the appropriate payee.

Some see escrow accounts as a lender protection, put in place to avoid losing the collateral (i.e., the house) to unpaid tax liens or natural disaster, in the event of a lapsed homeowner’s insurance policy. Others see escrow accounts as protecting the homeowner’s interests from the same dangers and adding an element of convenience that simplifies the financial obligations of owning a home.

There are a number of implications that arise when an escrow account is put in place for a loan:

• Sticker shock prevention. Property taxes are collected by most counties twice per year. With an escrow account, the lender collects a prorated amount toward the annual tax and insurance bills every month, preventing borrowers from getting socked with a big lump sum tax bill that is harder to pay.
• Convenience. Homeowners who have their taxes, insurance and even HOA dues collected via escrow account make a single payment monthly that covers all these bills, rather than having to write multiple checks on different schedules to the mortgage company, tax assessor, insurance company and HOA. This minimizes the discipline and organization required to pay all these items consistently on time.
• Lost interest. Most escrow accounts do not bear  interest,  though some states do require escrow accounts to pay at least a small interest rate. Some consumer advocates bemoan the loss of potential interest homeowners could be earning on their tax and insurance monies. Owners with sufficient equity in their homes to opt out of having an escrow account can replicate the convenience of an impound account, without the disadvantage of lost interest, by having the monthly allotment of tax and insurance funds automatically directed to an interest-bearing savings account until it is time for the bi-annual tax and insurance payments.
• Fluctuations in  monthly  payment. Usually, lenders adjust escrow accounts and, thus, their borrowers’ escrow payments, on an annual basis. Property taxes,  assessments  and insurance premiums change annually, so escrow accounts need to be tweaked to match. As such, even if you have a 30-year fixed rate mortgage, with an impound account, your monthly mortgage payment may change from year to year. (Realistically, though, without an escrow account, the non-mortgage costs of ownership will still fluctuate -- they just would not impact the actual mortgage payment.)

Once upon a time, escrow accounts were optional for almost all borrowers. These days, lenders require escrow accounts on all loans with less than 20 percent down. Without an escrow account, the borrower must exercise disciplined savings practices, or face the consequences when the big tax bill comes due. If you do not have an escrow account, but you want one, most lenders are happy to put one in place for you. However, once you have an escrow account and decide you no longer want it, it can be tough to get rid of it.

NOTE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.