Escrow is by definition a financial medium – such as a bank account -- administered by a third party on behalf of two other parties. While not unique to the mortgage industry, mortgage escrow accounts are one of the most common examples of this term. It is not the responsibility of the escrow administrator to make decisions about how to distribute escrow funds; instead, the administrator distributes funds in the escrow account according to the lender's instructions.
Mortgage lenders set up escrow accounts to fulfill legal requirements of your mortgage loan or lender-based regulations; they also set them up at your request. The intent is to ensure you have funds on hand to pay regularly scheduled quarterly, semiannual or annual payments such as real estate taxes, homeowners insurance and private mortgage insurance. Regulation Z of the Truth in Lending Act makes establishing an escrow account a legal requirement for specific "high-priced" mortgages. Effective June 13, 2013, the escrow account must remain active for a minimum of five years. Lender-based regulations most often require an escrow account any time you borrow more than 80 percent of the value of the home.
Normal Balance Accumulation
All escrow accounts accumulate a positive outstanding balance over time. To fund the account, the lender determines in advance how much you need to pay expenses over the coming year. The lender then prorates, or divides the sum into 12 monthly installments, and adds this amount to your monthly mortgage payment. If nothing changes over the course of the year, the outstanding escrow balance reaches zero by Dec. 31 of the current year and the process repeats itself for the next year.
Positive Outstanding Balance
The most common cause of a positive outstanding balance is lender-based "cushioning." Section 10 of the Real Estate Settlement Procedures Act allows your lender to prorate and add to your monthly escrow payment the equivalent of two months of escrow payments as insurance against a price increase in any of the escrow elements during the current year. At year's end, however, your lender must provide you with a year-end analysis of your account and refund any outstanding balance in excess of $50. If the balance is less than $50 your lender has the option to refund the outstanding balance or use the amount in prorating escrow payments for the coming year.
Negative Outstanding Balance
Mid-year increases to any of the required elements in your escrow account can result in a negative outstanding balance at the end of the current year. For example, a change in your homeowner's insurance policy may increase premiums, creating a negative outstanding balance. If an outstanding negative balance is less than the amount of one month's escrow payment, you must clear the negative balance yourself within 30 days. If the outstanding negative balance is at or over one month's escrow payment, Regulation X of RESPA allows your lender to prorate the negative amount, add it to your normal escrow payment and allow you to reduce a negative balance to zero over the next two to 12 months.
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