Escrow accounts give lenders the sense of security

Q: I am interested in handling my own escrow account on my Federal Housing Administration mortgage. However, my loan officer told me FHA rules prohibit this, but he was unable to provide a reference to these rules.

Is my broker correct? Do Veterans Affairs-backed mortgages have similar rules? Also, I’m aware that some states have laws instructing mortgage lenders to pay interest on escrow accounts. Is Washington one of them?

M.N., Edmonds

A: Your loan officer is correct, FHA regulations require that your monthly mortgage payment must include impounds into a reserve account sufficient to pay your annual property taxes and homeowner’s insurance.

VA loans also require reserve accounts. Most conventional mortgage lenders will allow you to pay your own taxes and insurance, but you must have at least 20 percent equity in the property. I will explain this further below.

Contrary to popular belief, the main reason mortgage lenders require impounds is not to make extra profits from the interest they earn on your money – although they certainly do make some money – but to make sure that the property taxes and insurance premiums are paid in a timely manner.

When a lender gives you a $270,000 mortgage on a $300,000 house, that house is their sole collateral for the loan. If you fail to pay your property taxes and the house is sold at a tax auction, the lender’s security interest in the home is wiped out. Likewise, if you fail to pay your homeowner’s insurance and the house burns to the ground, the lender can’t sell the pile of ashes to recoup its loss. That’s the main reason they want to make sure that property taxes and insurance payments are made on time.

As for your second question, Washington state does not require lenders to pay interest on the money they hold in mortgage escrow accounts. I understand your frustration. Many borrowers feel they are being “ripped off” by being forced to pay 1/12th of their property tax and insurance bills to their mortgage lender every month when that money could be earning interest in a savings account.

But put it in perspective. Savings and money market accounts are currently paying less than one percent annual interest. Even if the lender held an average of $2,000 of your money for an entire year – which is very unlikely because property taxes are paid every six months – you’d lose less than $20 worth of interest. Hardly worth worrying about.

However, some people just like to feel in control and not pay their property taxes or homeowner’s insurance any sooner than they absolutely have to. If you refinance your home with a conventional loan, you can “waive impounds” as I described above. Because there is more risk to the lender if you pay your own taxes and insurance, they typically require that you have at least a 20 percent equity in the home so that you have something to lose as well.

That means your loan balance can be no more than 80 percent of the total value of your home, whether it is a purchase loan or a refinance. Also, many conventional lenders charge an extra one-time fee of one-quarter “point” (0.25 percent of your loan amount), if you choose to “waive impounds” and pay your own property taxes and insurance. This is to help offset some of their risk and make up for the interest income they would have earned on your impound account during the life of the loan.

So if you feel strongly about paying your own taxes and insurance on your home, you are welcome to do so if you have enough equity in your home and you’re willing to pay slightly higher loan fees.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435, or e-mail him at economy@heraldnet.com.