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Escrow Account


Definition of "Escrow Account"

In a home mortgage transaction, a deposit account maintained by the lender and funded by the borrower, from which the lender makes tax and insurance payments for the borrower as they come due. Lenders generally require escrow accounts. The rationale is that it prevents a weakening in the protection provided to the lender by the property. If the taxes are not paid, the tax authority could place a lien on the property that would have a higher priority than the lender's lien. Similarly, if the house burns down or is flooded, the lender's protection goes with it if the insurance premiums had not been paid. Size of the Account: To assure themselves that there will always be enough money in the account, lenders ask for more than they actually need as a 'cushion.' In years past, many of them maintained unreasonably large cushions. To deal with that, the Department of Housing and Urban Development (HUD) issued a ruling that placed a ceiling on the size of escrow accounts, which in turn limited the amount the lender could ask the borrower to deposit at closing. The rule is that the deposit cannot exceed the amount needed to prevent the balance from falling below an amount equal to two-months worth of tax and insurance payments at its lowest point during the year. Reasons for Avoiding Escrows: The least important reason borrowers may want to avoid escrow is to capture the interest earnings on the account for themselves. The amounts involved are small. The more important reason is to establish control over the payments. Lenders require escrow to assure that the payments will be made, and borrowers may want to avoid escrow for the same reason. Lenders occasionally screw up, and when this happens it can be a nightmare for the borrower. Ways to Avoid Escrow: Most lenders will waive escrow requirements if the borrower makes a down payment of 20% or more. The logic of this waiver is that if the borrower has that much equity in the house, it is safe for the lender to rely upon the borrower's self-interest to pay the taxes and insurance premiums.



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