Q. A large part of my monthly mortgage payment is the tax and insurance escrow, how is this account established?

A.  An escrow account or sometimes referred to as an impound account, is established by a mortgage lender to collect and disburse tax and insurance payments.  It is the mortgage lender’s decision whether the borrower must maintain an escrow account for the purpose of paying taxes and other items.  However, most all mortgage lenders require an escrow for loans that have less than a 20% down payment or a loan to value in excess of 80%.  Certain government mortgage loan programs and secondary market sales of home loans will often require escrow accounts as a condition of the mortgage loan as well.

Mortgage lenders set up the escrow account to receive monthly payments from home buyers to then in turn pay for these obligations as they come due on the  items such as annual insurance premiums, real estate taxes and assessments. 

Mortgage escrow accounts work something like a forced savings account for the homeowner’s tax and insurance bill.  The money to pay the annual property taxes or semiannual or in some cases, quarterly property taxes is deposited and  saved in the escrow account that is managed by the mortgage lender or mortgage servicer and then disbursed by the mortgage lender on or before the tax and insurance due date.  The money that is accumulated or deposited in the escrow accounts comes from a portion of the monthly mortgage payment made by the home loan borrower. 

There are regulations that limit the maximum amount of funds that a mortgage lender can require a borrower to maintain in an escrow account.  During the term of the home loan, RESPA rules prohibit a mortgage lender from charging excessive amounts for the maintenance of an escrow account.  Section 10 of the Real Estate Settlement Procedures Act (RESPA) limits the amount of money a mortgage lender may require the borrower to hold in an escrow account for the payment of taxes, insurance, etc.  RESPA rules also require that the mortgage lender provide initial and annual escrow account statements.

The amount that needs to be placed in the escrow account initially and the amount of the monthly payments are determined by the cost of insurance and a tax assessment of the property.  This amount will often fluctuate each year as insurance premiums rise or maybe fall and property taxes rise or may fall. 

Each month the mortgage lender may require the home loan borrower to pay into the escrow account no more than 1/12 of the total of all disbursements payable during the year, plus an amount necessary to pay for any shortage in the account.  In addition, the mortgage lender may require a cushion, not to exceed an amount equal to 1/6 of the total disbursements for the year.

The mortgage lender is required to perform an escrow account analysis once during the year and notify the home loan borrowers of any shortage or excess funds ion the escrow account.  Any funds held in excess of $50 or more must be returned to the borrower.

The process for calculating the mortgage escrow account starts with all the payment amounts or disbursements that will be paid out of your escrow account.  This is usually the property tax bill and homeowner’s insurance bill. This total amount of insurance and taxes and other assessments if they apply are totaled up and divided by 12 monthly payments. 

A trial running balance can then be calculated for the next 12 months listing all the monthly payments into the escrow account and all payments that the mortgage lender will pay out of the account when they are due.  From this point, there is generally a time when the escrow account would reach a negative balance.  In other words, when the first tax payment comes up there will likely not be enough money in the escrow account by simply adding then previous month’s monthly payments. 

The next step is to increase the amount of money deposited so that all the monthly balances  in the account, including the lowest point in the account, is at least zero so there is never a negative balance.

Finally, a reserve is added by the mortgage lender which may be added to the monthly balances.  The escrow reserve amount may be a maximum of 1/6 of the total escrow charges.

When there is a deficiency in the escrow account which occurs because the mortgage lender has to use their own funds to pay a one of the disbursements, the home loan borrower will have to reimburse the mortgage lender.  When the deficiency is less than one monthly escrow payment, the home loan borrower may have to repay the mortgage lender by adding to the next monthly payment to make up the deficiency in 30 days.  If the deficiency is more than or equal to one monthly escrow payment, the mortgage lender may require the home loan borrower to repay the amount over a period of 2-12 months.

The annual escrow account statement summarizes all escrow account deposits and payments during the mortgage lenders or servicer’s twelve month computation year.  The annual escrow account statement also notifies the home loan borrower of any shortages or surpluses in the account and advises the borrower about the course of action being taken.