Ever since I bought my first house, the concept of escrow payments has always seemed unfair to me. Many banks will allow you to stop making escrow payments to them, but they charge a fee for it. Is it worth it? Just how bad is escrow, and does it make sense to pay a fee to end it?
What escrow is, and why banks like it
Escrow is when banks collect money from you in advance, hold it on your behalf, and then use that money to make payments such as real estate taxes and home insurance for you. The main advantage for banks is that escrow protects their collateral, which is your home.
If you didn’t pay your real estate taxes then your local government would put a lien on your property. That would complicate the process of foreclosing on your home in the event you also stopped making your mortgage payments.
Similarly, banks like making your insurance payment for you so they can be 100% sure it has been made and you are properly insured. If you didn’t make your insurance payment and didn’t have any coverage when your house burned down then your bank would not be happy. Without insurance coverage, they find themselves having made a large loan to you where their only collateral is a pile of ashes on a lot.
Why escrow is a bad deal for consumers
There are several reasons why most consumers don’t want escrow, including a lack of flexibility. My previous house didn’t have escrow on the mortgage. I used the flexibility of being able to make the payments when I wanted to my advantage for income tax purposes.
When I did my tax return every year, I found that my itemized deductions fell just short of the standard deduction. That means that the mortgage deduction you hear so much about wasn’t doing me any good. So what I started doing was making double the real estate tax payment every two years.
The first year I would make sure that two years worth of real estate tax payments had been made in the same calendar year. Being able to deduct two years worth of real estate taxes on one income tax return gave me enough deductions so that my itemized deductions exceeded the standard deduction.
In the second year, my itemized deductions were far below the standard deduction amount, so I just took the standard deduction amount. It was a bit complicated to keep track of, but when done right I would have to pay less income taxes every two years.
Another reason I don’t like escrow on mortgages is if you are able to save money on one of the payments being escrowed, you won’t be able to see those savings for a long, long time. Last year I shopped my homeowners insurance and was able to save a couple hundred dollars.
But, my escrow payment is only recalculated once a year. That meant I had to keep paying the higher rate to my bank for the next year even after they had made the lower insurance payment. For the next year, I watched my escrow balance get higher and higher and higher throughout the year. Eventually I got this money back, but having to wait a year to see any actual money from lowering your bills takes all the fun out of the whole process.
The most common reason people don’t like escrow is interest. Without escrow, I could keep my money in a savings account and earn interest on that money until it was time to make my annual payments. With escrow, the bank holds on to that money for me and I don’t earn a dime, although a small interest payment is required in just a few states.
Just how much does this lost interest cost me?
To figure out how much you are not earning on interest every year because that money is being held by the bank, multiply the average balance in your escrow account by the interest rate you could be earning. Right now, it is hard to find a savings account that pays more than 1%. The average balance of my escrow account is $1,600, so I am only losing out on $16 per year. I may not like the idea of escrow, but the reality is that it really isn’t that expensive.
At some point in the future interest rates will eventually rise, and then having an escrow on your mortgage will seem more expensive. If the interest rate on a savings account eventually goes up to say 5%, then the lost interest on that average escrow balance of $1,600 will still only be $80 a year.
Some lenders will let you cancel escrow, but may charge a fee to do so. As much as I dislike escrow, it probably doesn’t make sense to pay this fee. Fees vary by lender, and you should compare your savings to the fee in order to see if getting out of escrow is a good deal or not.
Many people would recommend a payback period of no more than 3 years for this kind of transaction. That means you can take your annual savings, and multiply by 3. If that number is larger than the fee to get out of escrow, then you might want to consider paying that fee.
For example, in my case I am losing out on $16 a year, which would be $48 over 3 years. If the fee to cancel escrow is more than $48, I might be better off just gritting my teeth and continuing to pay escrow each month.