Your Guide to Prepaid Expenses and Escrow in the Homebuying Process

One of the biggest sources of confusion for homebuyers and refinancers alike is how an escrow—also known as an "impound account"—is calculated and how it affects the bottom line at closing. This lack of knowledge can raise the stress level for many home buyers.

Escrow accounts are common in real estate transactions, but you may also find this type of account used in international commerce and business mergers.

Terminology

First, let’s clarify the terminology used. The differences in language are mostly geographic. Some states use the word “escrow,” while others use the term “impound.” These are exactly the same thing and the same as one person calling a soft drink a "soda" and another portion calling it "pop."

The first thing to note and emphasize is that money going into an impound account is not a cost of undertaking a loan. It is still the buyer's money. These funds are held by the bank or another third-party until the real estate transaction is complete. They are like a guarantee or contingency account that the buyer will be able to complete the transaction and their obligations. Often these funds are used to pay property taxes and insurance on the home.

Real Estate Escrow Accounts

When a bank or other financial institution underwrites a loan for a big-ticket item—like a home—it wants some assurance that the property it is lending money for is protected. It wants to make sure the property taxes are paid each year so there are not outside claims. It also wants to make sure it is insured in case the house faces a fire or other hazard.

Although the impound account is designed to protect the lender, it can also be beneficial for the borrower. Each month, an amount equal to a portion of the annual property tax and insurance coverage is added to the loan repayment amount. In this way, the buyer can pay for these large expenses gradually throughout the year. Depending on the home's location, size, and other details, taxes and insurance can thousands of dollars per 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.

Initially, the account will need to be funded. How much is needed to pre-fund the account is determined by how many months the new owner will own the home in the current year. Most often, the amount can be added to the total value of the loan.

For low-down-payment borrowers, an escrow account is usually not optional. 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 homeowner's insurance in the event that the property is damaged.

In other words, if you are putting less than 20% down, you can expect to be required by your mortgage lender to have an escrow account.

At the conclusion of the loan process—whether you paid off the home through refinanced or sold the property—you get any money left in the account back. The lender is required to send you the check within 60 days of loan payoff.

What Are Prepaid Expenses?

Prepaids are expenses or items that the homebuyer pays at closing before they are technically due. They are necessary to create—or "pre-fund"—an escrow account or to adjust the seller's existing escrow account. Prepaids can include taxes, hazard insurance, private mortgage insurance, and special assessments.

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. As mentioned earlier, the lender divides the annual cost of each type of insurance into a monthly amount and adds it to your mortgage payment.

Each year, your lender will recalculate the amount needed to be held in your escrow—impound—account. Property taxes change each year—as with all taxes, usually up—as does the cost to insure your home. The lender will estimate a monthly portion for what will be due next year. If, for some reason it miscalculates, you may have to make up the difference in taxes and insurance funds.

How Do Your Escrows Affect Cash to Close?

Your escrow deposit will vary based on the time of year in which you close your loan in comparison to the month in which your property taxes are due.

If you closed on a loan in February, you wouldn't make your first payment on that loan until April. If your property taxes are due in January, they will have just been paid. That means your initial escrow deposit will be small. Your lender has plenty of time to collect escrows before the next disbursement.

As an example, on a $500K property, that's about $2,000 for property taxes even in a basic tax zone, and if your insurance is $1,200 per year, you would have to come up with another $400 for that $2,400 into the impound account.

Your homeowner's insurance is always paid in full, plus two months if you are purchasing a home.

Using the same $500,000 loan amount, suppose you were closing on a refinance in October. You originally bought in February. You are only going to make two payments (December and January) before the insurance is due, so your impound total for the insurance alone will be $1,000.

You are going to have to come up with $3,000 to pay the first half of your property taxes, plus because you only have two payments before the second half is due, another $3,000. Total due: $7,000.

The cash amount that fixed-rate borrowers think of as their monthly payment is still subject to change–that is one of the biggest issues with impound accounts. Since homeowner's insurance and property taxes are subject to change, monthly payment amounts can fluctuate.

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.