What happens if a borrower forgets to pay property taxes or lets homeowners’ insurance lapse? The answer can be costly for everyone involved. Fortunately, escrow accounts provide a simple solution that helps prevent these problems before they occur.
INTRODUCTION
Setting up escrow accounts to collect taxes and insurance is well worth the effort. Rather than relying on borrowers to save for large annual expenses, escrow allows these costs to be collected monthly along with the loan payment. This structure helps borrowers’ budget more effectively while reducing risk for the lender.
Many borrowers—especially first-time homeowners—are not accustomed to budgeting for the full cost of homeownership. Escrow helps them manage these expenses more easily and reduces the risk of missed payments. For lenders, this added structure helps protect both the property and the loan investment.
WHAT IS AN ESCROW ACCOUNT?
An escrow account is a separate account that holds the borrower’s funds to pay property taxes and/or insurance premiums when they come due. Escrow is not a fee charged by the lender and does not generate a profit. The funds in the escrow account belong to the borrower, not the lender. Its purpose is to ensure that required property-related expenses are paid on time.
Insurance premiums are typically paid in advance, meaning escrow funds are used to pay the next insurance renewal before coverage expires. Property taxes are typically paid in arrears for the previous tax year, with payment typically due in the later part of the year or, in some jurisdictions, at the beginning of the following year. The escrow account is designed to estimate monthly collection amounts, collect payments, and ensure on-time payments for both obligations.
BENEFITS OF ESCROW ACCOUNTS
Escrow accounts help borrowers budget for taxes and insurance, simplify the payment process, and ensure these obligations are paid on time. They also provide important benefits to lenders by helping protect their collateral and reducing financial risk.
For the Borrower
- Spreads large annual costs into manageable monthly payments
- Reduces the stress of lump-sum tax or insurance bills
- Help ensure taxes and insurance are paid on time
For the Lender
- Reduces the risk of tax liens against the property
- Helps maintain the lender’s first-lien position
- Protects the collateral securing the loan
- Reduces the risk of uninsured property losses
Escrow does not change the principal or interest of the loan payment. Instead, it adds the tax and insurance portion to the monthly payment, with those funds being deposited into the borrower’s escrow account for future disbursement.
MANAGING ESCROW ACCOUNTS
If an escrow clause was not included in the original mortgage note terms, the borrower must voluntarily agree to establish an escrow account. In most cases, the only circumstance in which a lender can require escrow after closing is if the borrower becomes delinquent on property taxes and/or insurance, subject to the loan documents and applicable law.
If you use a third-party loan servicer, they will typically handle communications to the borrower regarding both voluntary escrow and any escrow requirements resulting from delinquency. If you self-service your loans, consult an attorney before setting up force-placed escrow accounts.
The easiest and safest way to manage escrow is through a professional loan servicer.
A loan servicer typically:
- Collects monthly loan payments, including escrow funds
- Serves as the primary point of contact for borrowers
- Assists with payment and escrow-related issues
- Pays property taxes and insurance premiums when due
- Maintains escrow accounting and compliance
- Provides required reporting, including mortgage and tax statements
For lenders who self-service loans, escrow funds should be maintained in a separate, dedicated bank account, preferably held by an independent third party. Remember, an escrow account requires timely payment of property taxes and insurance premiums and ongoing accounting oversight. Because escrow accounts are subject to legal and regulatory requirements, always consult an attorney before managing escrow accounts yourself.
WHAT IF THE BORROWER DEFAULTS ON TAXES OR INSURANCE?
Even when an escrow account is not in place, borrowers remain responsible for paying property taxes and maintaining required insurance coverage. If they fail to do so, lenders may have several options, depending on the loan documents and applicable state law.
- Insurance lapse: The lender may be able to obtain force-placed insurance to protect their interest. Always consult an attorney to ensure compliance with your loan documents and state laws. Also, ensure you as the lender are listed on the policy as a mortgagee or loss payee.
- Tax delinquency: A lender may choose to pay delinquent property taxes to prevent a tax lien from taking priority over the mortgage and then seek reimbursement from the borrower. In many cases, a tax default may also allow the lender to require escrow going forward.
- Voluntary escrow: Even when borrowers are current on their obligations, lenders may offer escrow as a budgeting tool that helps borrowers avoid large annual bills while ensuring taxes and insurance are paid automatically.
SUMMARY
Escrowing property taxes and insurance benefits both borrowers and lenders. It helps borrowers’ budget for significant recurring expenses, promotes timely payment of taxes and insurance, and protects the lender’s collateral and lien position.
Using a professional loan servicer to administer escrow accounts is strongly recommended, as it can significantly reduce administrative burden and compliance risk. For future seller-financed transactions, lenders should also consider including escrow requirements in the terms of the mortgage documents.
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