Mortgages are complicated things. One thing that can be super confusing is when you have a fixed rate loan, you would think that your mortgage payment would never change. In most cases, that's not true. How can your fixed rate mortgage payment change? Fixed rate mortgage payments change due to changes in the escrow portion of the account.
What Is Escrow?
The majority of mortgages in the United States include an escrow account, which is a special type of bank account. In the case of mortgage escrow, this is a savings account that is used to pay expenses that are directly related to owning the home. Escrow accounts are sometimes called impound accounts. These typically include real estate taxes and homeowner's insurance, but also may include things like homeowners' association fees, flood insurance, or other expenses.
When you have a fixed rate mortgage, the principal and interest portion of your mortgage payment doesn't change, but the escrow portion of your mortgage payment may change each year (rarely, more often.) This change happens for two reasons that are inter-related:
- the actual amount of expenses paid from the escrow account last year were different from the amount anticipated, and/or
- the anticipated amount of expenses for next year have changed from the previous year.
Why Do We Have Escrow Accounts?
When a lender loans you money to buy a house, they need to protect their investment. Because tax bills always take precedent over mortgage bills, the mortgage company needs to ensure that those tax bills are being paid. Similarly, ensuring that necessary insurance coverage is maintained makes sure that the value of the home is protected if there is damage. By paying the tax and insurance bills themselves, the mortgage company decreases their risk from unpaid tax bills or homeowners' association bills or lapsed insurance coverage.
Many mortgage companies require that these bills be paid through an escrow account. In some cases, you may be able to skip the escrow account and pay these bills directly. This may require a fee to the mortgage company, or you may pay a higher interest rate, or you may need to have a lower loan-to-value ratio. If you would prefer not to maintain an escrow account for your taxes and insurance, check with your lender to see if their loan terms permit this.
How Escrow Works
In order to understand how this works, you must have a basic understanding of how an escrow account works. First, escrow accounting usually happens on a yearly basis, so think in terms of a year. It is very rarely a calendar year, but a 12 month period of time. You make a payment into your escrow account each month. Over the course of the year, the various bills arrive, and the bank pays the bills out of the escrow account.
At the beginning of the year, the bank calculates how much money you will need to put into your escrow account each month to make sure that there is enough money in your account to pay all your bills when they arrive. They do this by running a quick 12 month projection of what will happen when you put in money each month and they pay the bills. They calculate how much money you will need to contribute each month to ensure that you will always have enough money.
By law, they are allowed to include a buffer of two month's escrow payments to allow for unexpected increases in the bills that are paid from the escrow account.
Your yearly escrow estimates are provided to you ahead of time. The first year's is included in all that mortgage paperwork, and future years are included in an escrow analysis statement that is provided every year.
How Your Escrow Changes
At the end of each 12 month period, your mortgage lender will perform an escrow analysis. An escrow analysis has two parts: looking at the past year, and looking at the upcoming year.
The first part is a simple check to compare last year's actual expenses with the expenses projected at the beginning of the term. It's very rare for the actual expenses to match up perfectly with the projected expenses - there are too many factors that can change the expense amounts. As a result, there is usually an over-payment or a shortfall on your escrow payments for the entire year.
If you've overpaid on your escrow account, you will receive a refund of the amount overpaid. If it is less than $50, the lender may apply it to the next year's escrow account.
If you have a shortfall in your escrow account, you will have two choices: you can pay the shortfall in full, usually by mailing a check or making an online payment, or you can spread the shortfall payment out over your next year's escrow payments. Typically, the default choice is to spread the shortfall payment out over the following year. This is one reason why your mortgage payment can go up: you're paying the shortfall from last year's escrow over the year.
The second part of the escrow analysis is a repeat of the original projections, looking at the upcoming year. It will use the most current information to figure out costs for the next 12 months, and determine how much you need to put into escrow each month to cover those costs. This amount may be more or less than last year, so this is the second reason why your mortgage can go up.
Why Is It So Hard To Get Escrow Amounts Right?
Projecting escrow activity is almost impossible to do accurately because of the nature of the costs that are being paid out of the account and because projections are using last year's information to anticipate next year's costs.
Property taxes and homeowner's association fees change regularly, and notice of those changes typically occurs only a few months before the bill is due. In most cases, those costs only increase, though they can rarely decrease. In particular, property taxes can go up significantly if you move out of a property on which you were claiming any type of primary residence exemption. None of these changes can be anticipated when the mortgage company is doing the projection portion of your escrow analysis.
Insurance costs can go up or down based upon a wide variety of factors. You may choose to purchase flood insurance, or increase the deductible on your homeowners' insurance, or install a new alarm system, or put on an addition. You may move out of the property and switch the homeowners' policy to a fire (rental) policy. Every time you make a change to your insurance policy, your premium will change. Once again, the mortgage company can not anticipate these changes when it does your escrow projection.
Because the mortgage company can not anticipate how your expenses will change over the upcoming year, it does the escrow projection based upon last year's figures. It's very rare for expenses to remain the same two years in a row, so it is also very rare for an escrow account to balance perfectly at the end of the year.
What If You Think Your Escrow Amount is Wrong?
When you receive your yearly escrow analysis in the mail, don't dump it in the recycling or throw it in the shredder. Take 15 minutes to look over what happened in the last year and what is projected to happen in the next year. Ensure that the amounts listed for the expenses are right, and that the math makes sense.
If you see something wrong, there are two things you can do: ask for a re-analysis, or wait until next year. If you see an error on your escrow analysis, hop online or call your mortgage company. If the error is in last year's information, review the escrow account activity for the last year to figure out what has gone wrong. If you see something wrong in the projections, communicate that information to your lender and ask them to re-analyze your account. If you don't ask for a re-analysis, it will get analyzed again in 12 months and get worked out then.
Mortgage escrow accounts are one of those things that are completely confusing until one day it just all makes sense. It's one of the few things in this world that I understand really well, so please ask me your questions!
