Chances are that, if you’ve considered purchasing a home, you’ve heard the term ‘escrow’. An escrow account, more commonly known as a property tax account, is a specific type of account for mortgages. It plays an important role in conveyancing, the legal process of transferring real estate ownership between parties. To determine whether your home purchase can benefit from an escrow account, it’s important to understand what to expect from this process.
What Is A Mortgage Escrow Account?
Unless you are going to pay for the home outright, you’ll need a mortgage to make the purchase. Upon the purchase of the home, you are responsible for paying property taxes annually. You can opt to have them collected by the mortgage lender as a component of your mortgage, then submitted by the lender to the municipality annually.
When you use an escrow account, your annual property tax amount gets divided up and applied to your monthly or biweekly mortgage payments. For each payment, the portion that’s to go towards your property taxes is placed in the escrow account. Once it comes time to pay the annual amount, the lender sends the money to the municipality.
How Does An Escrow Account Work?
When you get a mortgage, a part of the process is to appoint an escrow agent, where the term specifics are set forth in an agreement. The nature of the agreement depends on how you plan to use the escrow account. If it is meant to address the property taxes between the transmission and transfer of the title, then the agreement can be for merely a couple of days. Conversely, if you plan to continue using the property tax account over time, then the agreement term can last for years.
It used to be widely accepted that the conveyancing law firm negotiated the agreement when seeking an escrow agent. However, since the role of the agent is to protect your assets during the agreement period, many real estate brokerages pursue entirely independent escrow agents. This is to ensure that there is no possibility of conflict of interest, since the parties are all separate, the funds are held neutrally so as to offer a safeguard against foul play.
If you’re a senior, learn how you can defer your property taxes to save some money.
When Are Escrow Accounts Required When Buying A Home?
In most situations, using an escrow account is not mandatory. That said, there are situations where it is necessary. High-ratio mortgages with less than 20 percent in down payment typically require an escrow account. Since there is less equity in the home, it is viewed as a technically higher risk of default in terms of both mortgage and property taxes. Should the property taxes not be paid, the municipality could force the lender to sell the property to recuperate those taxes. To mitigate this risk, the lender makes an escrow account essential.
Pros Of A Mortgage Escrow Account
When it comes to escrow accounts, whether they suit your needs is a matter of balancing advantages and disadvantages. In order to understand how an escrow account could work for you, take a look at the pros and cons of these property tax accounts. There’s a wide range of benefits to opting for an escrow account, including:
Automatic Payments
Instead of fretting about an extra payment, the escrow account takes over the responsibility. When the property taxes come due, the municipality forwards the lender an invoice and supplies you with a copy. After the account is established, there are no further steps for you to take. Plus, since the account can have the property taxes collected biweekly, it prevents you from having to save towards a large amount annually.
Covers Any Funding Gaps
Escrow accounts are structured to regulate any deficiencies in balance by adjusting the amount the following year. In general, escrow accounts have the liberty to go into a negative balance without any repercussions. The lender will pay the municipality the property tax in full and simply adjust the amount taken and held in escrow accordingly the following year.
For example, if your taxes for this year are $6,000, the lender will put $500 per month into escrow and pay the municipality when taxes come due. The lender will then continue to collect that $500 per month into the next year.
However, say your taxes are raised the following year to $6,400. The lender will put the escrow account into a negative state (that $400, less any accrued interest that can be put towards the tax bill). The following year, the lender will divide the $400 by term, collecting instead approximately $533 each month. This is done over the term of the mortgage to balance any shortfalls.
Lower Mortgage Costs
Surplus balances in escrow accounts are not common, but it can happen in situations where the lender collects more than is needed to pay property taxes. Many escrow accounts don’t pay interest (or if they do, it is nominal). In these situations, you can request that the overage get refunded directly to your account. However, you can also use this surplus to temporarily reduce your mortgage payments. The lender will adjust the property tax component of your mortgage payment up until the surplus is used up. During that time, you can reap the convenience of lowered mortgage payments.
No Surprise Expenses
Perhaps the biggest advantage to having an escrow account is that there are no surprise costs. The lender is responsible for paying the property taxes on your behalf. This means no budgeting for a large annual expense, or having to deal with the shock of property tax increases. The payment constitutes a part of your mortgage; so, as long as that account is in good standing, you don’t have to worry about surprise expenses.
Check out our guide to budgeting and saving for a mortgage.
Cons Of A Mortgage Escrow Account
There are some downsides to having an escrow account that you should be sure to consider. Among the negatives of having an escrow account are:
Automatic Payments
Though there are benefits to automatically paying property taxes, it also takes the payment out of your hands, literally. Convenience aside, your property tax is not actually a part of your mortgage. You will continue to owe this amount after the mortgage is discharged.
Automatic payments means that, whenever your mortgage payment is withdrawn, proceeds for your property tax are taken as well. This means that you do not have access to that liquid cash during the year. If you get an annual bonus, or have alternative means of making that large payment, you may not need an escrow account.
Large Deposit
In many cases, generating a property tax account means a substantial investment upfront. These are typically termed as closing costs during the conveyancing process. It translates to the equivalent of insurance costs and the property tax for several months.
Few Earn Interest
Escrow accounts are convenient, sure, but they are not profitable. Seldom do property tax accounts accrue interest, meaning you might be missing out on short-term investments available. If the money placed into the escrow account could instead go into a high-yield investment portfolio, the funds can be put to better use than simply sitting in the account. If you are a responsible budgeter and prudent investor, there is a chance you can gain more by avoiding an escrow account.
Potential Fraud
Because of the niche nature of property tax accounts, they are a unique target for cybercriminals. These accounts are not regularly attended, simply receiving deposits and holding them, in escrow, until tax time. Due to this lack of oversight, fraud opportunities are prevalent. From dummy websites to phishing email scams, there are many cyber thieves who aim to steal personal information and money.
The real risk is that you are not monitoring the account, rather it is under the purview of your lender. Incongruous communication regarding deposits can open vulnerabilities for consumers. Though any account is technically susceptible to these scams, the nature of escrow accounts makes them particularly attractive to thieves.
Additional Reading
How To Cancel An Escrow Account?
Provided the escrow account is not a mandate of your mortgage, it should be fairly straightforward to cancel. In situations where the lender requires the escrow account, you can make a request based on having more equity in the home than when the account was opened. While there is no way of ensuring approval, keeping your mortgage in good standing over time goes a long way to getting that approval.
Conversely, if it was by choice that you opened the account, you can simply contact the financial institution and cancel the agreement. There may be an administrative fee associated with the account cancellation. Many consumers have reported delays in processing when closing an escrow account; however, as long as it is within your rights to close the account the process is simple.
Escrow Account FAQs
Do funds in escrow accounts earn interest?
What happens if I have extra money in my escrow account?
What can I use instead of an escrow account?
What happens if I have too little money in my escrow account?
Final Notes On Escrow
Mortgages and property taxes are separate. You will be paying property taxes in perpetuity whereas a mortgage gets discharged. When it comes to deciding whether an escrow account is right for you, it comes down to a choice between convenience and control. If you prefer to avoid thinking about your property taxes altogether, then an escrow account can offer significant benefits. Conversely, if you prefer to control your cash flow as much as possible, you can save the money for property taxes on your own. The key is ensuring that both your mortgage and property taxes are paid in full and on time, whether or not you choose a property tax account.
