One of the most confusing parts of having a mortgage is understanding how the payment on your fixed rate mortgage can change, usually every single year. In order to understand why your payment changes, you need to know your escrow account works. An escrow account is an account that pays different bills related to the property, usually taxes and insurance but also sometimes homeowners association fees, special assessments, or other appropriate expenses. An escrow account may be required or it may be voluntary.
Each year, the bank estimates how much money you’ll need over the course of a year to pay for the items you are having escrowed, and figures out how much you have to save each month for those expenses. They use the figures they have available, which may be a quote from your insurance company or tax assessor, or it may be the amount of last year’s bill.
In this regard, it’s just like any other savings account you may have. For example, I put $500 each month into a savings account for health care expenses, based upon on estimate that we’ll spend $6000 per year on deductibles, co-pays, dental, and vision needs. (Yeah, we spend a lot on vision.)
At the end of a year, the insurance company compares what they’ve actually spent vs. what you’ve contributed. Another way to look at it is that they compared what they actually spent vs. what they estimated they were going to spend. They see whether you’ve paid enough into the account each month to cover the expenses that you had. If the actual expenses were higher than the estimated expenses, you’ll have a shortage. If the actual expenses were lower than the estimated expenses, you’ll have an overage. If you have an overage, they’ll usually send you a check (unless it is very small.) If you have a shortage, you will have the option of paying it all at once or paying it installments over the next year.
Then, at the same time and as part of the same process, they’ll estimate for the next year. They’ll figure out your new needed escrow deposit each month based upon the information they have at that time, using the same process of adding up all the bills for the year and dividing it by 12 months.
You usually have a choice of how to handle the shortage: pay it in full, or spread it out over the next year’s payments.
Your new escrow payment will be the new monthly payment as calculated based upon the costs estimated for next year, plus any shortage from last year that you chose to spread out over the year.
I know some people hate using an escrow account, but I am fond of them. It simplifies my life by ensuring that my most vital bills get paid, and I don’t have to bother with estimating myself and making that savings account deposit each month. I might feel differently if my mortgage bank was misbehaving, but so far Navy Federal Credit Union has always gotten the bills paid on time, and I earn a tiny bit of interest on that money sitting in my escrow account. I’m all about anything that makes my life easier!
Please let me know if you want me to explain it a different way! Sometimes it takes hearing the same thing a couple of ways to understand it.
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