How to Avoid a Mortgage Escrow Nightmare

When you get a mortgage to purchase, build or refinance a home, most lenders prefer to set up an escrow account so they can pay your property taxes and insurance premiums for you.

A monthly payment is added to your mortgage bill and analyzed once a year to cover any increases in taxes or insurance premiums.

Sounds simple, right?

Actually, mortgage escrow is one of the most difficult aspects of loan servicing.

Here's a guide to understanding what's going on.

Buying or Building a Home

Home buyers don't always consider the taxes and insurance carefully enough -- especially if they are moving to different state.

Property taxes; In many states, property taxes are reassessed the year after a home is purchased or built. This means that your property taxes may go up significantly in the second year you own the home.

When the lender sets up your initial escrow payment, the payment will be based on the property taxes of the previous owner. If you have had a house built, the initial escrow payment will be based on the taxes on the unimproved lot.

Homeowner's insurance: The lender will have a much easier time figuring out how much to charge you monthly to cover homeowner's insurance, because you will be required to obtain an insurance policy before you purchase the home or at the time your home construction is completed.

If you are moving to a new state, it is important to scope out homeowner's insurance rates before you decide on the home purchase or construction.

If you move from the Northeast to a state around the Gulf Coast, for example, your insurance costs can increase several times over. In some areas, homeowner's insurance policies don't cover hurricane or earthquake damage, and you will need to buy an additional policy to cover those perils.

Toward the end of the real estate run-up, I spoke with several troubled mortgage borrowers who had built investment homes in Florida, seeking to flip them for a quick profit.

After several hurricanes, homeowner's insurance premiums for unoccupied homes were very high and policies were almost impossible to find in some areas. These borrowers were under tremendous pressure, as the insurance premiums were unaffordable and the homes were suddenly difficult to sell or rent out.

Escrow Analysis and Trouble

Each year, the lender or loan servicer sends an escrow-analysis letter. This letter lists the escrow payments collected from you over the past year and the tax and insurance payments made by the servicer. It is when you receive the first or maybe the second escrow analysis that trouble can begin.

Consider the following scenario:

You purchase a home in January 2006. The loan servicer pays your 2006 property taxes in November 2006. You receive your first escrow analysis letter in January 2007, and see that your payment is staying about the same. In November 2007, the loan servicer pays your reassessed property taxes, which have gone up by $2,400.

When you receive your second escrow analysis letter in January 2008, be ready for a big surprise!

The bank needs to collect an additional $2,400 for property taxes each year, so your monthly payment will increase by $200. But what about the $2,400 shortfall for last year? That's right, your payment is actually increasing by $400.

What do you do now? For starters, call the loan servicer and ask to speak to a loan escrow specialist.

You should be presented with a few options:

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