Did you think that when you stopped renting and started owning, you'd finally get your deposit back for good? Think again. When you buy a house with a down payment of less than 20%, your lender may require you to make a deposit on your homeowners insurance, private mortgage insurance, any required additional insurance (like flood insurance) and your property taxes. (Learn more about home insurance in Beginners' Guide To Homeowners Insurance.)
How It Works
An impound account (also called an escrow account, depending on where you live) is simply an account maintained by the mortgage company to collect insurance and tax payments that are necessary for you to keep your home, but are not technically part of the mortgage. The lender divides the annual cost of each type of insurance into a monthly amount and adds it to your mortgage payment.
Required Mortgage Impounds
Since low down payment borrowers are considered to be a higher risk due to their lower personal stake in the property, lenders want some level of assurance that the state will not seize the property because of non-payment of property taxes, and that borrowers won't be without homeowners insurance in the event that the property is damaged. An impound account ensures that the only person who will become owner of the house in case of default will be the lender.
Optional Mortgage Impounds
Even if an impound account is not required, one can be elected at the loan signing. But is that a good idea?
Some consumers would rather set money aside in a high-interest savings account, and feel that impound accounts are a bad idea. Not all states require lenders to pay interest on the money held in impound accounts, and those that do may not pay as much as individuals could earn by investing the money on their own.
Further, if the mortgage company does not pay bills - like property taxes and homeowners insurance - when they are due, the homeowner will still be on the hook. Therefore, homeowners should be aware of the due dates for these payments and monitor their impound accounts carefully. (Take a look at Five Tricks for Lowering Your Property Tax for ways to reduce your tax bill.)
Although the impound account is designed to protect the lender, it can also be beneficial for the borrower. By paying for big-ticket housing expenses gradually throughout the year, borrowers avoid the sticker shock of paying large bills once or twice a year, and are assured that the money to pay those bills will be there when they need it.
Monitoring Your Impound Account
Your monthly mortgage statement will probably show the balance in your impound account, making it easy for you to keep a close eye on it. Federal regulations also help borrowers out in this area by requiring lenders to review borrowers' impound accounts annually to ensure that the correct amount of money is being collected. If too little is being collected, the lender will start asking you for more; if too much money is accumulating in the account, the excess funds are legally required to be refunded to the borrower.
The cash amount that fixed-rate borrowers think of as their monthly payment is still subject to change – this is one of the biggest issues with impound accounts. Since homeowners insurance and property taxes are subject to change, monthly payment amounts can fluctuate, affecting monthly cash flow with little warning. (Read Understanding the Mortgage Payment Structure for more information.)
Required impound accounts also decrease the amount of money borrowers can place in an emergency fund. The lender keeps a little extra in your impound account, in order to ensure the extra cushion needed in order to keep making insurance and tax payments if you stop making your monthly mortgage payments. This cushion is collected when you acquire the loan. Thus, the startup costs associated with impound accounts can increase the amount of cash buyers need in order to purchase a house in the first place.
Low down payment buyers don't need to maintain impound accounts forever, though. Once sufficient equity (often 20%) is achieved, lenders can often be convinced to ditch the impound account.
For many homeowners, mortgage impounds are a necessary evil. Without them, lenders might not be willing to give mortgages to borrowers with low down payments. The best way to deal with impound accounts is to understand how they work, monitor them carefully and get rid of them when you can. (If you're interested, read The True Economics of Refinancing a Mortgage and Make Yourself a More Attractive Mortgage Candidate for related topics.)