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You can pay your homeowners insurance premiums and property tax bills through an escrow account or on your own. Here are some things to consider if you’re weighing your options.
The Basics of Property Taxes and Homeowners Insurance
When you set up an escrow agreement with a lender, your monthly mortgage payments include the principal, interest, property tax, mortgage insurance, and homeowners insurance.
Property taxes are paid to your local government once or twice a year. If you have an escrow account, a portion of your monthly house payment is set aside until the property tax bill comes due.
The lender uses the money in your escrow account to pay that tax bill.
The amount of property tax you pay depends on the assessed value of your home. Usually, this is determined by an assessor.
The assessed value of your property is multiplied by the local tax rate to determine your tax bill.
Lenders usually prefer that you pay your tax this way so they can protect themselves. If you don’t pay property taxes, the property can have a lien placed against it, meaning that obligation must be satisfied before the house can be sold or foreclosed upon.
The lender must pay the property tax lien before reselling the property after the foreclosure.
A lender determines how much property tax you pay each month by dividing the yearly estimated amount by 12. That is added to your monthly mortgage payment.
Because it is only an estimate, you may have to add more money at the end of the year if the property tax was underestimated, or you may get a refund if the amount was overestimated.
Once a year, your escrow account will undergo an analysis, and you’ll be given an accounting of how funds were distributed. If there is an escrow deficiency, you can pay off your balance or roll it over and add it to your monthly payments for the new year.
Homeowners insurance covers repairing or rebuilding your home after events like fire, wind, hail, theft, vandalism, and other similar acts, although most standard home insurance policies don’t include earthquake and flood coverage. Most policies also cover furniture, clothing, other possessions, medical expenses, and legal fees for visitors in your home.
Although it’s not required by law, lenders usually require homeowners insurance in most cases to protect their investment in your property. Payments are made monthly to the insurance company providing coverage.
The PITI Formula
One of the standards in the mortgage industry is determining monthly mortgage payments using the PITI Formula. PITI is short for principal balance, interest, taxes, and insurance. These are the primary elements that comprise most of a monthly house payment.
Lenders combine these expenses to create a single monthly obligation you must pay each month, assuming you let the lender handle property tax and homeowners insurance payments on your behalf.
Your monthly house payment goes into an escrow account, and when it’s time to cover your property taxes and homeowners insurance payments, the lender will take funds out and make payments to fulfill your obligations.
All the work is done for you, and you only need to contribute a specified amount of dollars with each mortgage payment. You don’t need to worry about setting aside separate dollars every month, providing you maximum peace of mind and convenience.
Here’s an example of how PITI works.
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How Does an Escrow Analysis Impact Your Payments
An escrow analysis is conducted annually and involves the lender reviewing how much payment you made to cover your property tax and insurance. From this analysis, the lender can increase or decrease your escrow payment.
Mortgage companies usually require two months of payments in escrow accounts, so if your insurance and tax costs increase, there will be an escrow shortage. While your escrow balance may still be positive, the money left in it won’t be enough to cover future payments or could result in a negative balance in the future.
An escrow deficiency occurs when your escrow account has a negative balance. This happens after an escrow analysis determines that the lender didn’t take in enough money from you to cover your taxes and insurance.
When this happens, you can pay off the shortage or negative balance, or you roll the negative balance or shortage over into the new year and add it to your monthly payments for the new year.
The Pros and Cons of Making Payments on Your Own
If you don’t want to add your property tax and homeowners insurance to your monthly house payment, you can independently manage these two expenses and control payments on your own. There are several pros and cons to this approach.
- You remain in complete control of when you make these payments instead of an outside third party.
- This method works if you have financial discipline and trust yourself to make monthly insurance and semi-annual tax payments.
- Reduces the lump sum house payment you must make each month, giving you timing flexibility.
- You can put your dollars to better use instead of those same dollars sitting in a non-interest-bearing account managed by a mortgage lender. You don’t earn interest on your money when it’s in an escrow account.
- It’s less convenient if you want simplicity in your monthly outlays.
- Lenders prefer the stability of making payments connected to an escrow account.
- Some lenders require borrowers to enter escrow agreements if their loan-to-value ratios are 80% or higher.
- You may miss out on lower interest rates that lenders give borrowers when they pay property taxes through an escrow account. Some lenders may charge a fee to borrowers instead.
- You are more passive in managing your monthly house payment since the escrow account builds in automatic payments on your behalf.
- You must make a conscious effort to set aside dedicated funds for property tax and insurance payments.
- If you are not financially savvy and disciplined, or after an escrow analysis, you could wind up with a large lump sum bill totaling thousands of dollars at the end of the year.