Taxes are a huge part of your financial life. This is particularly true when buying a new home. While there are many tax benefits to owning a home, there are also tax liabilities, and many mortgage companies require you to pay upfront for them. This is referred to as "opening an escrow account."
What is an Escrow Account?
The escrow account for your mortgage can also be called a reserve or impound account. There are no laws that require an escrow account for your mortgage, but your mortgage company can require you open an escrow bank account. Generally, escrow bank accounts are for your annual tax and home insurance payments. You can also request that your mortgage company escrow these payments so that you have one less thing to worry about paying. The payments are added onto your mortgage payment each month.
While there is no law requiring escrow, the Real Estate Settlement Procedure Act (RESPA) of 1974, strictly controls how the lender handles your escrow account for mortgages.
RESPA protects homeowners in two main ways:
- It demands that no mortgage company can require excessive escrow deposits.
- It requires that mortgage companies provide homeowners an annual accounting of the escrow bank account. This accounting needs to reflect the amount of money in the account, the payments made into the escrow account and the charges taken out of the account.
These rules protect homeowners by assisting in comparison shopping of closing costs, prevents excessive fees and kickbacks being charged.
How Many Months of Taxes to Keep in an Escrow Account
Now that you understand a little about escrow accounts, just how many months of taxes do you need to keep in yours? The law is very clear on this point. RESPA prevents lenders from holding money in the escrow bank account. This means they can only charge the minimum amount, and then the regular monthly charges for the escrowed items. However, they are permitted to charge the full amount if the taxes are due immediately or within 60 days of the closing. The basic rule of thumb is the mortgage holder can hold no more than three months of payments at any one time.
The Bottom Line
Just how do you determine how much you need to fund the escrow account with at closing? It's a simple calculation. Take all the yearly reserves required by the lender to be escrowed. As you know, this can include taxes, property insurance and sometimes, other recurring costs. Divide the resulting number by 12 months. Next, multiply the monthly payment amount by the number of months required by the mortgage holder to go into escrow. The amount of fund required upfront into escrow at closing depends upon how near tax time is to the closing date. If it's within 60 days of tax time, the entire year of payments may be required at closing. If taxes are paid at closing, no more than three months will be required to be escrowed for next year's tax payments.