An escrow account is essentially a non interest bearing savings account, with the sole purpose of accumulating funds to pay your property tax and homeowner’s insurance bills in the future. This is often the most hardest to understand part of the closing figures. Escrow account balances are regulated – lenders are allowed to accumulate a cushion – so that the escrow account balance will never have more than a 2 month cushion, and never fall below a 2 month cushion. This cushion gives lenders some breathing room to cope with increased future tax and insurance bills. Read on to understand more.
Most mortgage lenders prefer to hold money in escrow to pay property taxes and insurance renewals in the future, so your closing costs are slightly reduced when you agree to escrow for taxes and insurance, and of course, some loans require escrow accounts. I estimate that 98% of my clients have an escrow account associated with their loan. With an escrow account, each month you pay a 1/12th portion of the estimated annual costs for property taxes and insurance along with your principal and interest. At the end of the year, the lender is required to provide you with an accounting of your escrow account. At that time must, if necessary, the lender must adjust your monthly escrow amount based on the actual tax and insurance bills. You will be asked to pay more, or will receive a refund if the escrow account is out of balance.
At closing, you will pay for a 1 year homeowner’s insurance policy, and your lender will pay to renew the policy before it expires. If you close on April 15th, your home will be insured through April 15th the following year. And if you close on April 15th, your 1st mortgage payment won’t be due until June 1st. So when your lender is paying to renew your insurance policy, you will have only made 10 or 11 payments. And that is why you will put 2 to 4 months worth of insurance into your escrow account at closing.
Property taxes in North Carolina can seem a bit more complicated. Property tax bills are published in August, with a September 1 due date. And the bills are for the full calendar year ending December 31st. Most lenders will pay tax bills in October or November. So in the example above, with an April 15th closing and a June 1st due date for your 1st payment, by November you will have only made 6 payments. So your lender could need to collect as much as 8 months of taxes from you at closing. But don’t worry – you get some back. In this example, you bought the home on April 15th, so the sellers owe you 3 1/2 months of taxes, which your closing attorney will collect from them at closing. So if your lender collects 8 months from you, and the sellers give you 3 1/2 months, then you have paid about 4 1/2 months of taxes net, at the time of closing.
Here is a chart that shows the rise and fall of escrow balances as payments come in and bills are paid.