Why Insurance Escrow is Necessary
Lenders use escrow to ensure their collateral is secure. It reassures the lender that, in the event of a disaster that destroys your home, you’ll be able to cover the remaining balance of the mortgage loan. Without escrow, lenders have no way of being certain you’ll pay your monthly premiums and your homeowners insurance could default.
Setting Up Your Escrow Account
New homebuyers typically set up an escrow account at closing. At this time, your lender will ask for around two months worth of payments in advance to secure your escrow account. The escrow holder will help you through this process. The Real Estate Settlement Procedures Act protects you from lenders requiring significant amounts of money to procure an account.
Your lender might require you to bundle your home insurance and taxes into your monthly mortgage payment. This is escrowing. When determining the amount of your monthly payment, your lender will consider four different things:
- Your principle payment
- Your monthly interest payment
- Your annual real-estate tax
- Your homeowners insurance bill
They’ll use these to determine how much money you’ll need to start your escrow account. These four factors are sometimes referred to as PITI for principal, interest, taxes and insurance.
The location of your new home will also affect your insurance rate. Areas prone to violent weather may cost more to insure than a place with mild climates. For instance, a home located in the Midwest, in the area known as Tornado Alley, is more likely to suffer weather-related damage than other homes around the country.
You’ll pay into the escrow account throughout the year. If, at the end of the year, you find you’ve paid more or less than you owed, you’ll either get the money back or will need to pay your remaining balance. Most lenders will let you choose between paying the balance upfront or spreading the remaining payments over a given period of time.
Missed payments on your insurance could cause you to become liable in the event your home is damaged.
The Pros vs. Cons
Some mortgages require you to set up an escrow account when buying a home while others give you a choice.
If you find that you’re unable to save money over periods of time, an escrow account might be the right choice for you. For example, let’s say your taxes for the year on your home are $2,500, to be paid out over the course of 12 months. You might also pay an insurance cost of $500 for the year. With escrow you’ll pay $250 each month in addition to your mortgage to cover both costs. Without escrow, you’d pay $2,500 on your yearly tax bill.
Foregoing homeowners insurance escrow could mean saving money by earning interest on the $2,500 you’ve saved over the year before paying the bill. It’ll also mean being saddled with a huge bill during tax season that you might not be able to pay if you fail to set aside the money, or if an unforeseen accident occurs that drains your bank account.
When It’s Right to Waive
Some mortgage lenders allow you to “waive escrow” if you have at least 20 percent equity on your new home. This situation only makes sense if you’re positive you can maintain your own insurance and tax bills on time.
Choosing to waive the escrow when buying a home can set you up for failure down the road. If you fail to make your payments, you could potentially lose your home in the event of an accident or disaster. This is why many mortgage lenders will forbid an attempt to deny escrow. They want to protect their investment, which ends up protecting you as well.
Mortgage lenders that allow you to waive escrow will typically refuse to offer you low rates they give to homebuyers who do agree to an escrow account. The lenders may also charge a fee to waive escrow.
Obtaining homeowners insurance escrow is a personal choice that can often lead to many benefits if you choose to do so. If you’re unsure if this is a good idea, one of our agents can help you decide if an escrow account is right for you.