When we are buying a home and financing it through a mortgage, the only expense we usually think about is the mortgage cost. Homebuying is associated with many other expenses as well, such as homeowners insurance and property taxes. These costs are payable at the end of the year or whenever due as per the development’s requirements.
Two Ways you can Pay Your Tax and Insurance Payments
There are two basic methods for paying your property tax and homeowners insurance. The first is to incorporate your property tax and insurance payments in your monthly mortgage payment. This is usually required by lenders as well, as it protects the lenders in the event of a foreclosure. The proportion of the funds that would be used to pay the tax and insurance is kept in the escrow account, maintained by the lender.
The second alternative is to forgo the escrow services and make direct deposits to your local tax and association offices. This means you can save the money yourself by setting aside a required amount every month, and paying when the insurance and taxes are due. It can help you lower your mortgage payments and utilize your money by avoiding idle funds. The escrow account won’t give you any interest or profit, but if you open up a saving account for the purpose of these payments, you can get a return on your money till you make the payments. This technique may make more financial sense. However, this alternative can only work if you are a good saver and are disciplined with your finances.
Additionally, tax and insurance payments can be tricky. It is strongly advised that you thoroughly research the pros and cons of both methods before making a choice. Nevertheless, the mode of payment you choose is not always at your discretion. If your loan-to-value ratio is 80% or higher, to offset the foreclosure risk, your lender would require you to have escrow arrangements with him/her.
Understand the Lowdown on Escrow Arrangements
An escrow account can be a useful tool for setting aside funds each month to cover insurance and property taxes. This entails entrusting the funds to a third party until the payments are due (usually at the end of each year), providing assurance that you have sufficient funds lying with your lender to cover these expenses and avoid any associated late fees or penalties.
Additionally, an escrow arrangement with your lender means that you pay your taxes and insurance in tiny payments instead of the entire amount after 6 months or at the end of the year. Plus, it becomes the lender’s responsibility to make timely payments to the offices. For some people, convenience comes at top of the list. So, if you are one of those, you got your answer!
However, to determine whether escrow is the best method of managing your monthly tax and insurance payment, you first need to understand the PITI formula. The PITI (Principal, Interest, Taxes, and Insurance) formula is a way to calculate the total monthly payment a borrower will make on a mortgage loan.
The total monthly payment you make to the lender is computed when these four components are added together. To determine the amount of property tax, the assessed property value is multiplied by the tax rate, and the resultant figure is divided by 12 to know the amount you need to pay every month. This is added to the homeowners insurance, principal payments, and interest payments per month to calculate your total monthly payment.
Get Familiar with the Escrow Account Balance
Lenders want you to maintain an escrow account balance equal to at least two months of property taxes and insurance payments. There are two terms that you should be familiar with if you have an escrow account with your lender: shortage and deficit. If your tax or insurance payments increase and your balance becomes insufficient to cover those, your account will have a shortage of money, as it won’t have the equivalent of 2 months’ payments. However, the balance won’t be negative. The deficit indicates a negative balance, meaning your account balance wasn’t enough to cover the needed expenses.
To offset these issues, a yearly analysis of your escrow account is conducted by the lender and the payment is adjusted accordingly. If the taxes and insurance have risen, so would your escrow payments, and vice versa.
The question remains how you are expected to manage the shortage and the deficit?! Well, it largely depends on you! If you have extra money, you can pay to maintain the balance and cover the shortage or deficit. Otherwise, the remaining payments would be rolled over to become part of your next year’s mortgage payments.
Know the Benefits & Challenges of Escrow Account
Let’s look at some of the advantages and issues of having an Escrow account:
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Convenience of Letting Lenders Manage your Funds
Letting your mortgage lender hold your property tax and homeowners insurance payments in escrow assures that those payments are made on time and on a regular basis. You get to avoid the stress of keeping track of the payments and their corresponding dates. This, however, requires you to give up control of your funds to a third party, enabling it to make payments on your behalf. -
Maintenance of a Balance
As the balance in the Escrow account should equal at least two months of property taxes and insurance payments, the saved money would give you peace of mind and decrease your anxiety about these expenses. However, while it may be convenient to have insurance and taxes included in your monthly mortgage payment, doing so may swell your payment and limit your spending options. Plus, you have to take account shortage and deficit into consideration as well. -
Maintaining Transparency
Escrow services offer transparency in the transaction process. All parties may follow the status of the transaction and the funds held in escrow, ensuring that everyone is on the same page. You will know exactly what to expect since the required escrow amount is added to your monthly mortgage payment. Your lender will give you written notice if the escrow portion of your monthly mortgage payment needs to be increased. Your lender would also provide you with an annual escrow statement that lists your payments as well as any overages or deficiencies.
Pay Yourself or Through Escrow
So the question remains, what should you do? Should you put money in Escrow or opt for the alternative way of leaving tax and insurance payments in Escrow? As discussed above, it depends on your lender’s requirements, loan-to-value ratio, and your own disciplined and saving nature. You should choose what best suits your financial and personal circumstances.
If your mortgage lender allows you to pay your property taxes and insurance directly to the appropriate organizations, you can have more control over your money and lower mortgage payments. When deciding which payment method to use for your mortgage, it is important to bear in mind the trade-offs between the convenience of an escrow account and the control gained by making payments independently. By factoring in all the variables, decide accordingly!
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