How To Avoid An Escrow Shortage
10 minute read
How To Avoid An Escrow Shortage
Taking out a mortgage can be an inundating experience, mostly because of all of the terms and documents that are constantly getting thrown around. For instance, what in the world is an escrow account?
If you’ve ever taken out a mortgage, you’re probably familiar with the concept. But even if you think you’re an escrow expert, you may not be totally comfortable with the ideas of overages or shortages.
Without knowing what an escrow shortage is, it already sounds pretty bad. So let’s uncover what an escrow shortage is, as well as ways you can avoid one from occurring.
What Is Escrow?
It’s pretty hard to know what an escrow shortage is without first understanding what escrow itself is. If you take out a mortgage, you’re likely to open up an escrow account.
Escrow accounts can be thought of like savings accounts that your mortgage lender operates. Every time you make a mortgage payment, your lender will deposit a portion of your payment into your escrow, which is a legal agreement where a third party controls money until two other parties have met certain transactional conditions.
In other words, escrow is a mediator that reduces risk on both sides of a real estate transaction, meaning yourself and your mortgage lender. Typically, you’ll need to deposit money into escrow before buying a home to show the lender that you are serious about purchasing the property. After following through, this money can be used to automatically go towards payment of taxes, homeowners insurance, or other fees.
Escrow can be handled by a mortgage servicer, escrow company, or an escrow officer. Typically, a real estate agent sets up the escrow account for you.
While escrow might seem like an unnecessary nuisance, it can actually make your life a whole lot easier. By consolidating the cost of taxes and other fees into your monthly mortgage payments, you only need to worry about paying one bill rather than several at the same time.
What Is An Escrow Shortage?
Part of it will go towards your principal and interest balance itself when you make monthly payments. The other portion needs to be paid towards property taxes and homeowner’s insurance. The amount of money put into the escrow account is determined by a yearly escrow analysis.
Once a year, your lender will review your account to ensure enough funds are collected to pay for upcoming insurance premiums and other fees. The difficulty with an annual escrow analysis is trying to estimate exactly how much you’ll need to pay towards taxes in the upcoming year.
In most cases, your escrow is underestimated, which is where an escrow shortage may come into play. When you have an escrow shortage, it means that you’ll need to pay more out of pocket towards monthly expenses rather than being able to use the money that’s in your escrow account.
Essentially, an escrow shortage occurs when you do not have enough money in your escrow account to cover the amount needed to pay off your monthly bills. Commonly, this happens when there is an increase in the property taxes for your home, resulting in more money needing to be taken from escrow in order to cover the charges.
How Does Escrow Work?
Let’s break down escrow so you can visualize how a shortage happens:
Your annual tax payment is projected to be $2,500. $2,500 divided by 12 months in a year equals your monthly escrow payment (around $208). Additionally, your estimated homeowner’s insurance is $1,500 a month, so $125 will go to escrow each month.
So if you have a $1,500 mortgage payment, $1,167 will go towards your principal and interest while the remaining $333 goes to escrow.
Here’s the thing: Your annual escrow analysis determined that your property taxes have increased from what they were predicted to be. Your actual total comes out to $3,000 for your taxes and $1,750 for insurance. That’s an extra $750 that you weren’t expecting to pay.
Since you’ve only deposited enough into escrow to cover what was originally predicted, you’re now responsible for the difference. This usually comes in the form of a higher mortgage payment each month in order to cover the newly assessed taxes and homeowner’s insurance.
Can You Avoid an Escrow Shortage?
Avoiding an escrow shortage is, unfortunately, nearly impossible. This is because you can’t always anticipate changes to the cost of your insurance or tax costs. With that said, you can try to be proactive to lessen the chance of a shortage occurring.
Have some additional savings set aside just in case an escrow shortage increases your monthly payments. Additionally, keep a close eye on your escrow account to see if you can predict that your account balance will become too low to cover monthly fees.
Pay attention to the information you get from the city regarding tax information, as well as any correspondence from your homeowner’s insurance company. They’ll often send you information about trends or possible increases in costs, which can let you plan ahead for an incoming escrow shortage.
Lower Your Escrow Payment
You can also reduce the chances of an escrow shortage by lowering the cost of your property taxes or homeowner’s insurance. This can be helpful for avoiding a shortage, as your escrow payment is tied directly to both of these factors.
You can dispute your property taxes or see if you qualify for tax exemptions to lower this variable and, in turn, get a more attractive escrow payment rate. Additionally, you can shop around for less expensive homeowners’ insurance policies from different services to help alleviate some of the financial burdens.
Opting Out of Escrow Payments
Under rare circumstances, you may be able to avoid escrow each month and, instead, pay your own taxes and insurance. While this will make your monthly mortgage payment lower, you’ll still need to make separate payments for property taxes and insurance on your own.
You might also be able to opt-out of having an escrow account if you refinance your mortgage. With that said, most states require that you have a certain amount of equity or down payment in order to waive the fees.
Even though you might be able to get out of using an escrow account, there are very few reasons why you’d want to. Escrow is a great convenience, as it can break down some of your payment obligations into more manageable pieces throughout the year.
Most people find that easier than needing to write one large check to cover property taxes and other insurance premiums.
Is There Such Thing as an Escrow Overage?
While it’s less common, it’s entirely possible that you may actually be owed money from your escrow account. An escrow overage occurs when the taxes and insurance premiums are less than projected, and you have more money in your escrow account than you actually owe.
When this happens, you’ll probably get a refund check for that amount at the end of a 12 month period. You can use that check for anything, but it might be a good idea to put it towards your monthly mortgage payments.
Escrow Shortage vs Escrow Deficiency
If you have an escrow shortage, it means that you still have money in your escrow account — it’s just not enough to cover your tax and insurance bills.
However, if you have an escrow deficiency, it means that you have a negative balance in your account. This happens if your bills come due and you didn’t have adequate funds in your escrow to cover them. Your lender then pays the difference, which can save you from foreclosure, but you’ll still owe that money back to them.
This can sometimes get confusing because it might seem like you owe more than you think.
Here’s an example: Let’s say your escrow analysis revealed you still owe $1,000, but the only thing that happened is your homeowner’s insurance increased by $500. So why do you owe a full $1,000 instead of just the $500?
It’s because escrow acts as a bit of a safety net. The deficit not only means you need to pay $500 to cover the missed insurance charge, but you also need to put in another $500 to cover an incoming insurance charge so that it doesn’t get missed again. This will get you up to speed, so you don’t find yourself in a shortage.
Does a Fixed Rate Mortgage Lower Your Escrow?
Fixed-rate mortgages mean that you pay the same amount of interest during the entire term of your loan. Adjustable (or variable) rate mortgages can fluctuate over time. So if your interest is always fixed, the amount you pay in escrow must never change either. Right?
Unfortunately, it doesn’t really work that way. Keep in mind that it’s composed of two parts: principal/ interest and the escrow payment when you make a mortgage payment. While a fixed-rate mortgage won’t change what you pay in interest each month, your escrow payments will remain the same regardless.
While this might sound a bit strange, think of it this way. The local government determines the cost of property taxes, and insurance companies determine homeowner’s insurance.
These are completely separate entities from your mortgage lender. So even though a fixed rate will allow you to pay the same on your mortgage payment each month, your escrow payments are based on completely different factors.
How Do You Pay Off an Escrow Shortage?
If you find yourself in an escrow shortage, you have a few options as far as repaying it. For one, you can pay the balance in full. So if we use the example from earlier, if you owe $1,000 to your escrow, you can choose to deposit the entire lump sum into your escrow account at one time.
When you do this, keep in mind that you may still notice your monthly payments rising because of the change in property tax costs and homeowner’s insurance. With that said, it won’t be as high as it would be if you choose to make monthly payments.
If you make monthly payments, the adjusted amount will be added to your escrow payment every month. In this instance, you’ll be responsible for paying an extra $83 each month to cover the difference.
Your escrow account is a handy tool that can help consolidate your monthly payments into one bill. And while it can alleviate many burdens, it can be frustrating if there aren’t enough funds to cover the costs of certain monthly fees. When that happens, it’s known as an escrow shortage.
While there’s really no way to completely avoid an escrow shortage, as you can’t predict what the property taxes in your area will be, you can try to lower your escrow payments by diminishing your property taxes or homeowner’s insurance. Additionally, you can try to opt-out of paying escrow, but you’ll still need to make payments towards insurance and other premiums.
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