Federal Housing Administration (FHA) loans require escrow accounts for property taxes, homeowners insurance and mortgage insurance premium (MIPs). Rather than paying taxes directly to the government and insurance premiums to the insurer, an FHA borrower pays toward these expenses each month with his mortgage, with the money being placed in an escrow account. The proceeds from this account are used to pay the tax and insurance bills when they come due.
An escrow account serves as a holding account for the property tax, the homeowners insurance, and the MIP payment. Each month, in addition to his principal and interest payment, the homeowner pays an estimated one-twelfth of his yearly tax, insurance, and mortgage insurance payment. The escrow account holds this money until the bills become due. At this point, monthly escrow payments for the following year are adjusted up or down based on whether there was a shortage or surplus in the account for the current year's payment.
A MIP is a type of private mortgage insurance (PMI) endemic to FHA mortgages. The FHA requires a borrower to pay MIPs when his down payment is less than 20% of the purchase price. These premiums pay for an insurance policy that protects the lender in case the home is foreclosed, and the lender cannot recoup the full loan balance. With a lower down payment, there is less equity in the property and a greater need for MIPs.
An FHA borrower can stop paying MIPs when her loan balance drops to 78% of the home's appraised value at the time of purchase. In a situation where a homeowner gains equity through value appreciation, she can apply to have MIPs removed if her equity is over 20% based on a current appraisal and she has a good payment history.