Owning a home comes with plenty of operational expenses, including property taxes. While you can choose to manage your property tax payments yourself, you also have the option to have your lender manage these payments for you by rolling them into your mortgage payments. If you opt for the latter, your lender will use an escrow account, also known as a “property tax account”, to hold these funds and remit them to the municipality on your behalf.
Let’s go into more detail about these accounts to see how they work in a real estate transaction.
Key Points
- In a real estate transaction, an escrow account can be used by lenders to manage and remit property tax payments on behalf of borrowers.
- If there’s a surplus in your escrow account, the excess amount can either be refunded or used to lower the share of property taxes from your mortgage payments.
- If there’s not enough money in your escrow account, you may be allowed to have a negative balance for a certain amount of time, and the periodic payment amount is increased to make up for the shortfall.
What Is A Mortgage Escrow Account?
A mortgage escrow account can refer to a property tax account, which your lender will use to hold money you provide and use it to pay your property taxes when they’re due. As mentioned, you can opt to have these taxes collected by the mortgage lender by rolling them into your mortgage payments. When your lender collects your mortgage payments, a portion will be kept aside in this account and submitted annually to the municipality. In this way, your lender serves as an escrow agent, which is an independent third party responsible for holding and distributing funds.
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 outlined in an agreement. The nature of the agreement depends on how you plan to use the escrow account.
If the account will only be used to handle 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 was 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 to offer a safeguard against foul play.
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 — which are mortgages with less than 20% down — typically require an escrow account. Since there’s less equity in the home, it’s viewed as a higher risk for 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 could require an escrow account if they’re tasked with paying property taxes on your behalf.
Pros Of A Mortgage Escrow Account
There’s a wide range of benefits of escrow accounts, including the following:
Automatic Payments
Instead of having to manage your property taxes on your own, you can have them automatically paid on your behalf. When the property taxes come due, the municipality forwards the lender an invoice and supplies you with a copy.
No Big Annual Bills
Since the escrow account can have the property taxes collected for each mortgage payment, it prevents you from having to save towards a large lump sum amount to pay.
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.
If your taxes increase the following year to $6,400, the lender will put the escrow account into a negative state (in this case $400). The following year, the lender will divide the $400 by the number of mortgage payments, collecting instead approximately $533 each month. This is done over the mortgage term to balance any shortfalls.
Lower Mortgage Costs
Surplus balances in escrow accounts are not common, but they can happen in situations where the lender collects more than is needed to pay property taxes. In these situations, you can request that the overage get refunded directly to your account, which can temporarily reduce your mortgage payments. The lender will adjust the property tax component of your mortgage payment until the surplus is used up.
No Surprise Expenses
Another big 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.
Cons Of A Mortgage Escrow Account
There are also some downsides to having an escrow account that you should be aware of, such as the following:
Automatic Payments
Automatic payments can be considered a perk and a drawback, depending on how you prefer to have your finances handled. Though there are benefits to automatically paying property taxes, it also takes the payment out of your hands, literally.
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, 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 escrow account.
How To Cancel An Escrow Account
Closing an escrow account is relatively simple and straightforward, as long as it’s not a mandatory part of your mortgage. Simply contact the financial institution and cancel the agreement. There may be an administrative fee associated with the account cancellation.
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.
Final Thoughts
Having your property taxes paid via an escrow account managed by your lender comes down to convenience versus 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 manage property taxes on your own. The key is ensuring that both your mortgage and property taxes are paid in full and on time, whether you choose a property tax account or not.
