08/08/11: Do You Have to Escrow for Taxes
By Benny L. Kass
Why does your lender require you to escrow money so that it can pay your real estate tax and your home owner’s insurance policy?
If you listen to the lending community, escrows (also called impounds) assist you in managing your budget. Instead of having to make one large payment yearly (or semi-annually depending on how often the real estate tax is due), you send one-twelfth of your tax obligation to the lender, who will pay it for you when due.
Additionally, lenders claim, escrows give you comfort and peace of mind that your home is protected.
However, if you listen to the consumer advocates, escrows are just another way for lenders to make a little more money. The consumer is required to pay the lender – on a monthly basis – additional moneys which the lender will hold until the insurance or the real estate tax bill comes due. In the meantime, with few exceptions, the lender does not have to pay interest on those funds.
Furthermore, consumers point out, the great majority of homeowners do not want to lose their home and will make valiant efforts to timely pay their real estate tax bill as well as their yearly insurance obligation.
Finally, there are many instances where the lender failed to make the payment on a timely basis, causing the property to be subject to a tax sale. Although these cases are usually resolved at no financial harm, they do, however, cause a lot of anguish for the homeowner.
If you are buying residential real estate in the District of Columbia, and if you will be making a down payment of twenty percent (or more) of the total purchase price, you have the absolute right to pay your own real estate taxes and insurance. In fact, the law in the District specifically requires your lender to give you a separate, written statement before you go to closing, advising you of this right. This right also applies to a refinancing, where your equity equals or exceeds the twenty percent number.
Some lenders try to get around this by telling their borrower "yes, you can avoid escrow, if you will pay at settlement a quarter point of your loan amount". Alternatively, the lender will allow the borrower to avoid escrows only if the mortgage interest rate is increased.
It is my opinion that borrowers should not be required to pay anything extra in order to take advantage of a consumer protection created by law.
In Virginia, to my knowledge there are no laws involving escrows. Lenders will require escrows from consumers, unless the borrower has a good relationship with the lender, and can convince the lender that the taxes and insurance will be promptly paid when due.
Maryland law is partially consumer friendly. A first trust lender on residential real property must pay interest to the borrower on the funds in any escrow account, at the greater of 3 percent per annum or the regular passbook savings account paid by the lender. However, interest does not have to be paid if the loan is purchased by an out-of-state lender through such groups as Fannie Mae or Freddie Mac and the out-of-state lender will service the loan. As a practical matter, I suspect that the majority of Maryland loans will not require interest to be paid since they are serviced outside of the state.
However, effective October 1, 2011, there are new rules regarding Maryland escrow accounts. If the lender determines that the escrows must be increased – because the real estate tax has gone up –the lender cannot charge interest or fees on the amount of the increase for one year. But if the lender (or servicer) is required to advance its own funds to pay the tax or the insurance premium, then the lender – only after giving the borrower written notice that the advance was made and that interest will be charged on that advance - can charge that interest.
If you do opt to escrow – or if you have no alternative because you are not putting 20 percent down – how do you know if the escrow amount set by the lender is correct? Jack Guttentag is known as the "mortgage professor". His website has a very clear explanation of how to calculate the escrow deposit required at closing. (www.mtgprofessor.com).
Many years ago, as a result of numerous scandals involving real estate settlement, Congress enacted the Real Estate Settlement Procedures Act – commonly referred to as RESPA. According to the Department of Housing and Urban Development (HUD), the government agency which administers RESPA, the act does not require the lender to insist on an escrow account. "The HUD regulations only limit the maximum amount that a lender can require a borrower to maintain in an account." (HUD FAQs About Escrow Accounts for Consumers.)
According to the RESPA regulations, a lender is allowed to maintain a cushion of approximately two months of escrow payments. Let’s take this example: you are buying your condo and settlement is set for August 31. Your projected real estate tax is $2000/year and is due September 30. At settlement, the September tax bill will be collected and adjusted between buyer and seller.
But your first month’s mortgage payment will start in October. If you make your payments each month, the lender will have 12 months escrow with the September, 2012, payment, and that will be enough for the lender to pay the tax bill.
However, since you may be late next September (or may have missed a payment along the way), the lender at closing will charge you two months of escrow– as a cushion.
As can be seen, if settlement takes place in a different month, the escrow required at closing will be much higher – even without the two month cushion.
Lenders are known to make mistakes, and sometimes the lender does not pay the real estate tax or insurance. My suggestion: every homeowner who is required to escrow should send the lender a letter – by certified mail, return receipt requested – demanding proof that the tax and the insurance has been paid. This letter should be sent no later than one month after the tax and the insurance premiums are due.