DaveWentzel.com All Things Data
Are escrow accounts for suckers?
My "Pay Off Your Mortgage in 9 Years" post is surprisingly very popular. There are a lot of radio ads for programs that promise to pay off your mortgage early. Of course these services charge you a fee. There is NO magic to these programs, you can do these tricks yourself to pay off your mortgage early. I wrote that post because I rightly assumed that quite a few people do not know these tricks and I love to stick it to the banks whenever I can.
Today's "stick-it-to-your-bank" post is about escrow accounts and how they benefit the banks and not you, and what you can do about it.
What is an escrow account?
An escrow account is a bank account held by a third party (your mortgage company) which receives money from one party, such as the mortgagor (that would be you), and later distributes that money to one or many other parties. These "other" parties might be your hazard insurance company and your local property tax authority (usually your school district).
Why do banks want you to have an escrow account?
- Well, obviously they get to keep the interest on the float (the balance) in your escrow account. Banks don't need to credit your account for interest, at least not in PA. So they get a few bucks every year.
- People are generally lazy and stupid and banks would rather be the responsible party to make sure your hazard insurance and taxes are paid. If your house burns down and you didn't pay your insurance you might decide to default on your mortgage and that means the bank loses THEIR property. They don't like that. An escrow account lets them keep tabs on you to ensure your bills, that they have a vested interest in, get paid.
- Likewise, with escrow, if you default on your house the bank is guaranteeing that a taxing authority won't come in and get first claim on your house. Without escrow the bank doesn't know that you are not paying your taxes. With escrow, they know you are paying your taxes, because they are writing the check for you.
Many will argue that a couple of lost bucks in interest is worth it if someone else (the mortgage company) has the responsibility to actually get the bills paid. This is partially true. Read on.
Benefits of waiving escrow and paying your own bills
- With escrow you are locking up your money for potentially 12 months prior to a given payment needing to be made from the escrow account.
- Make some interest on the money you would normally have in escrow. Or pay a little more on a credit card. Or do anything else you want with YOUR money. Yes, the interest the bank makes on your escrow funds is miniscule...still, why let them have it?
- In my area I get a SUBSTANTIAL reduction in property taxes if I pay a month early. When I had an escrow account the bank only made the payment when it was due. In other words, the bank had the funds in escrow but did NOT make the early payment to save me money.
- In other cases it would have been advantageous from a tax perspective to pay the small late fee on a tax bill and reap HUGE tax benefits by moving the tax payment to the next year. It's rare, but it happens.
- Yes, it is true that it is LEGALLY the bank's responsibility to pay any and all bills for you (according to the terms of your escrow agreement), but that doesn't mean it won't cost you a ton of headaches when they screw it up. For instance, when I had an escrow account some of my tax bills went directly to the bank, others came to me and I needed to mail them to the bank. And the ones I needed to mail to the bank were the tax bills for a couple hundred bucks. It would've been faster for me to just write the check to the taxing authority rather than find the bank's address and escrow account information (and a stamp) to send it to the bank.
- This one is controversial, but it's true. As I mentioned in my previous mortgage post, there are unfortunately times when you may need to default on your mortgage. No one likes to think about this but it happens. In my last mortgage post I mentioned that PAYING DOWN (as opposed to PAYING OFF) your mortgage means that you are giving free money to the banks if you ever do, unfortunately, need to default. The same is true with escrow. If you can't pay the mortgage and escrow the bank will ensure the escrow is paid in full FIRST so the taxing authority doesn't seize your house. However, it usually takes a long time for a taxing authority to seize your residence. When funds are really tight, you are better off paying the mortgage first, and worrying about the taxes later. With escrow you can't do this. Obviously ALWAYS pay the hazard insurance first. ALWAYS.
- In the 7 years I had escrow I found discrepancies in my annual statement in 3 of those years. Check your annual escrow statements for discrepancies. In every case they paid the hazard insurance late because my insurer, unfortunately, sends out the bill exactly 30 days before it is due. My bank(s) couldn't handle such a small amount of lead time and decided to pay the penalties using MY escrow funds. That's not legally allowed, but banks don't always follow the law either. Once I disputed this in writing they credited my escrow properly, no questions asked. But this was still VERY annoying and time-consuming.
- Once I overpaid escrow throughout the year (another bank calculation foul-up) and had a huge balance at the end of the year. I received a letter indicating I could either get a refund check or apply some portion of the excess to next year's escrow and lower my monthly payment. Or I could apply the money to principle. Or...it becomes exhausting having to think about all of this. I would rather have a nice static mortgage payment for 30 years rather than a wildly fluctuating payment due to yearly escrow differences.
- I noticed at the end of one year that my escrow balance was hugely negative. The bank paid almost twice what my property taxes should have been. After a lot of research the problem was with the taxing authority...the wrong tax bill was sent to the bank and they paid it without asking questions. This is why I like to receive my bills at my home and scrutinize them. The bank didn't catch the error, but I would have.
- In another situation I refi'd in the middle of the year. My escrow account balance did not properly move from lender to lender. I was missing one month's escrow payment. I caught it only after reviewing the annual statement. What a nightmare trying to fix that.
- Lenders are legally allowed to keep an escrow balance equal to twice the monthly escrow payment. I had a lender actually delay a tax payment so they would not fall under the 2 month cushion. And they tried to have me pay the late fees. After I looked at the annual statement I noticed they did this the previous year too. The conspiracy theorist in me thinks that maybe the banks really do want an extra nickel of float interest at the risk of an irate customer. I hate banks.
- When you apply for credit there is a formula used called "debt-to-income ratio" (DTI) that determines if you are a good credit risk. The first question is always, "what is your income?". The second is, "what is your mortgage payment?". But the creditor never asks what portion of your mortgage payment is escrow or if you even have escrow. Therefore if you pay your own taxes your mortgage payment is lower and hence your DTI ratio looks better on paper.
How do you waive escrow?
- You may only be able to ditch your escrow if you refinance. Certainly don't refinance because you don't like escrow, but when the opportunity next presents itself, ditch your escrow.
- Ask. You'll probably need to have at least 80% LTV (loan-to-value), in other words, you'll need about 20% equity before a bank will consider this. Otherwise, again, strategic defaulting becomes appealing in bad economic times (see above). If you ask and you are a good customer it is likely that a bank will waive escrow for you. Most banks really do want happy customers.
(sample LTV calculation)
- This is rare: If you don't escrow when you refinance then make sure you read the fine print and make sure you are not paying any extra fee because of this. If the fee is small, and it usually is, it will be on your closing forms, then consider paying it anyway. Paying a fee is a rarity though. I was asked if I wanted escrow or not at my last refi.
When is waiving escrow a bad idea?
- If you must contractually pay higher mortgage rates because you don't have enough equity, then opt for escrow.
- If you are really terrible at budgeting and getting your bills paid on time, escrow is your friend.
- If your annual escrow statement shows LARGE negative balances then your bank can't properly estimate what your escrow should be and you are therefore getting free money from the bank. This is rare but happens whenever your property taxes go up by VERY large amounts quickly. Or when inflation gets out of control.