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Definition of Escrow

The Definition of Escrow - TAX ESCROW

Before we talk about the definition of escrow and escrowing for taxes, let me give a short explanation of what property taxes are.

Property taxes are fees charged to real estate owners (land or homes) by the municipalities (local government) in order to pay for maintenance and building of roads, schools, law enforcement, public employees' salaries, water treatment, etc.

If a home owner does not pay his property taxes, the local government can foreclose on the house and sell it on the courthouse steps to get the money owed.

If a citizen loses his home to the local municipalities due to non-payment of taxes, the lender stands to lose big-time. You probably thought the only way a house could go into foreclosure is if the buyer defaults (stops paying) on the loan.

But the IRS can take your home, the local government can take it, and, of course, the bank can take it as well. If a government agency takes the home, the lender may or may not be able to get their money back out. The lender can have what's left after the government gets their money, but there may not be anything left.

You can understand, then, why it would be in the best interests of the lender to make sure those property taxes are paid. Thus, the lending industry created the tax escrow account. The tax escrow account is like a savings account that the lender creates for you. You add to the account every month so that, by the time your taxes are due, there is enough money in it to pay your property taxes. This is how the lender comes up with the figures to create this account:

• The lender will forecast the amount of annual property tax on your home. In my area, the suburbs just outside Atlanta, GA, the annual taxes on a $200,000 home ran about $2500 last year. The lender will forecast that 2009 taxes will be slightly higher—maybe $2600.

• They will pro-rate how much of that total you will owe based on how long you will own the house until the end of the year of your closing. For example, if you close on your house on June 30, 2008, you will own the house for 6 months before the end of the year (July through December). That is exactly half of the year, so you will owe for half of the 2008 tax bill (half of $2600 is $1300). (The seller will pay for the 6 months that he owned the house—January through June-- as part of his closing costs.)

• The lender will also charge you for three months worth of taxes to create a cushion in the account so that it doesn't bottom out when they withdraw the money from it to pay your taxes. After all, they can only estimate what they think your taxes will be, so they create a cushion just in case they underestimated. So, you will pay a total of nine months worth of taxes as part of your closing costs—6 months worth for the part of the year that you will own the house ($1300), plus 3 months worth to create a cushion in the account to keep it from overdrawing ($650) for a total of $1950. The lender will put the $1950 in an "escrow account" that will be used for paying your taxes when they come due at the end of the year. This $1950 is included in the part of your closing costs called "pre-paid items" mentioned in the first bulleted section on page 1 under "PRINCIPAL".

• As I mentioned earlier, you will add to the account each month in order to make sure it will have enough money to pay your taxes at the end of each year. The lender will divide the entire annual tax bill into 12 equal payments and then add that onto your monthly mortgage payment. In keeping with our example thus far, we have said that the lender would probably forecast the total tax bill at $2600. Dividing that into twelve equal payments, that would put the monthly tax escrow payment at $216.66. Including our principal and interest payment of $1157.12, our total monthly mortgage payment is up to $1373.78.

But we are not finished yet. There are other "parts" to add if we want to get a realistic idea of what the total mortgage payment will be.

Learn more about the definition of escrow and other mortgage terms like PMI, principal, equity...