What Is Escrow & How Does It Work with a VA Loan?
What Is Escrow?
During the mortgage process, escrow can refer to both an escrow account and the money you put into that account.
While the VA itself does not require escrow as part of its standards for the VA loan program, you will likely still encounter it when you get a VA loan. That's because most lenders do require it as part of their internal loan guidelines.
In fact, you may even encounter two different forms of escrow and escrow accounts at different points in the process: once before closing and then after.
Escrow before Closing
The first point in the process where you'll encounter escrow is often after you've found your dream home and decided you want to make an offer.
Because of today's competitive market for homes, where sellers still have a slight advantage, you'll need to focus on making your offer as enticing as you can.
One way to do this is by putting what's called earnest money into an escrow account as part of your offer. Earnest money shows a seller that you're serious about buying their home—and you have the funds to back it up.
If the seller accepts your offer, your earnest money is taken out of the escrow account and applied to your loan. On other loan types, escrow usually gets applied to the down payment. However, since VA loans don't require any money down, your funds will usually get applied to your closing costs instead.
If your offer is rejected, you should get your money back, minus a small fee.
Escrow after Closing
The second time you'll encounter escrow during your VA home loan process is after closing. However, how escrow works in this situation is a bit different than how it works before.
After closing, you won't be making just one deposit into an escrow account. Instead, every month, a portion of your mortgage payment gets separated and placed into an escrow account by your lender.
Because your payment is made all at once, you might not even realize that you're contributing to an escrow account. However, most mortgage payments are actually divided into four different parts, often referred to by the acronym "PITI," which stands for:
It's the last two of these four that get separated out and held in escrow, and they refer specifically to property taxes and homeowners insurance.
Though your lender takes this money from you, it's not theirs to keep, which is why it gets placed in a separate escrow account until it's due. The first two portions (principal and interest), however, are theirs to keep.
Benefits of an Escrow Account
Setting up an escrow account for part of your mortgage payment comes with a lot of pros. Not only does it protect your finances and home in a variety of ways, but it also ends up protecting your lender as well. That makes it a win-win situation for everyone involved!
Budget for Your Insurance & Property Tax Payments
Easily one of the biggest benefits of using an escrow account is the ability to simplify budgeting for your homeowners insurance and property tax payments.
Essentially, your lender does the budgeting for you when they calculate what these bills will be. This calculation combines your home's property taxes from the previous year and adds them to your homeowners insurance premium. This total is then divided over 12 months.
The number that comes out is the amount you have to budget each month in order to have enough when your taxes and insurance are due.
While this kind of budgeting is certainly something you could do yourself, many homeowners don't realize how difficult it is when each payment is often thousands of dollars each, and they're only due once or twice each year.
Having a forced budget that's integrated into your mortgage payment makes being able to afford your taxes and insurance simple.
Prevent Late Payments & Fees
Because your lender controls your escrow account, they are also responsible for making sure your money gets distributed on time, which means you don't have to worry about remembering due dates.
It's easy to forget about things that only come around once per year, especially when life gets busy or stressful. Especially since, as a servicemember or veteran, you have a lot on your plate.
If your due dates happen to coincide with new PCS orders, a deployment, medical appointments, or even just family events, it's easy to see how you might not remember something that used to be 365 days away.
Avoiding late payments is important because they can have pretty dire consequences. If you are late on your property taxes, for example, you will have to pay late fees, which can sometimes be as much as thousands of extra dollars. In addition, making late property tax payments is usually considered a default on your loan agreement, which means your home could be placed in foreclosure.
Paying your home insurance late could also cause you to lose coverage. So, if your home were damaged, you'd have to pay for repairs out of pocket, which can also be incredibly expensive.
When you use an escrow account, you don't have to worry about these issues. By turning the responsibility over to your lender, they also become financially responsible for any consequences of being late.
Protect Your Home from Liens & Disasters
In general, lenders are highly motivated to remember your payments and due dates—and not just because they don't want to pay the late fees for you. They also want to avoid more serious consequences.
One of these additional consequences is that not paying your property taxes can lead to having a lien on your property.
Because this lien is placed by the government, it actually takes priority over the VA loan you owe to your lender. So, until your property taxes are paid and the lien is removed, your lender won't be able to recoup the money you owe them.
Then, when it comes to insurance, your lender needs your home to be protected because it serves as collateral on your loan. Normally, this means that if you don't pay your loan, the lender can resell the home to regain most of the money they lose out on when you can't pay. But if the house is damaged (and uninsured), then they have no way to get that money back.
With an escrow account, a lender knows that your home will be insured against damages and you'll have the money to cover your property taxes. It also means that you won't have to worry about losing your home because of a government lien or natural disaster.
Problems with Escrow Accounts
While escrow accounts have more positives than negatives, they aren't perfect. While some concerns are more serious than others, it's important to be aware of all the issues you could potentially face so that if you do encounter them, you won't be surprised or unprepared.
Extra Money Due at Closing
Because the company managing your escrow account is a business, they need to make money. Usually, they get paid a small portion of your home's price, and you pay them just once, when you close on your home.
Even though the additional fee for your escrow account is only about 1–2% of the loan amount, in real cash, it ends up being multiple thousands of dollars extra you have to bring to the closing table. Here's an example of what those numbers might look like:
As of May 31, 2019, the median sale price for homes in the US was $234,900. At 1–2%, that means you could be paying an extra $2,349 to $4,698 at closing.
That's a hefty chunk of change for the convenience of using an escrow account. But you might not have to cover all of it yourself.
When you're negotiating closing costs and who will pay what, you may be able to convince the seller to split the escrow account fee with you. Or, if you're lucky, you might even be able to get them to pay all of it.
Mortgage Payment Increases Caused by Shortages
Shortages are one of the more serious complications you can experience with an escrow account because they can potentially cause the most financial strain.
When projecting what your property taxes will be next year, your lender has to base them off of what they were this year. However, even though it's pretty common for property taxes to go up, your lender only finds out about it when they get the bill, which means you've been paying less than what's due.
The good news is that your lender will usually cover the shortage themselves in order to get the bill paid on time. However, you will have to pay them back plus cover the new increased estimate for next year, which means that the property tax portion of your mortgage payment doesn't just go up, it goes up double.
To help illustrate what that means, here's an example with some numbers:
Last year your property taxes were $1500. So, this year, to cover that amount, your lender charged you $125 each month as part of your mortgage payment. But when the received your tax bill, your property taxes actually ended up being $2,100, so you were actually short $600.
So, for this year, the new property tax estimate is $2,100, which means your monthly payment will increase to $175 ($50 more per month). But that only covers the future bill. You still have that $600 shortage from last year to cover.
Most lenders will give you time to pay that back over the next year, so they take that $600 and divide it by 12 months as well, which means another $50 increase to your monthly payment.
So now, thanks to just one increase, your monthly payment didn't just go up $50, it went up by a total of $100.
Luckily there may be a few options here for you. If you are a disabled veteran, you could qualify for a property tax waiver, if your state offers one. However, if you aren't disabled or otherwise qualify, or if your state doesn't offer a waiver, you're still not out of luck quite yet.
One option would be to contest the assessment that made your taxes increase in the first place. However, just be warned that this can be a time-consuming process, and the specific laws regarding how to do it and when it's due can vary.
Another option would be to work out a different payment plan for the shortage with your lender.
If you happen to have enough extra money, you could just pay the shortage all at once instead of adding it to your monthly payment. In this example, you'd pay the $600 right away and then your monthly bill would only go up by $50 instead of $100.
You could also just pay one part of the shortage and then budget the rest over the next 12 months. So, for the previous example, maybe you have an extra $300 you can give to your lender right away. Now you only have to budget an additional $300 for the next 12 months, and your monthly mortgage payment would only need to go up $75 total instead of $100.
Finally, you could see if your lender would be willing to give you more than 12 months to pay back the shortfall. Just be cautious of going this route, in case your property taxes keep rising. A longer payment plan could mean you just keep getting further and further behind on paying back your lender.
Not Earning Interest on Your Money
If your property taxes decrease, you get the opposite problem of a shortage, which is called an overage. While this might seem like a "good" problem to have because it means you get money back, it can still impact on your finances negatively.
For starters, you only get overage money back from your lender if it's above a certain amount. If it doesn't meet that threshold, you lender may hold onto it in case you experience a tax increase in the future. Again, still not the worst problem to have.
The biggest financial issue, however, with an overage is that you are most likely missing out on having that money—typically thousands of dollars—earn interest while it waits to get used.
Currently there is no federal law that requires your lender or escrow company to pay you interest. As for state laws, only 15 states currently require interest on escrow accounts in their legal code:
Sadly, if you live in any of the other 35 states, you're out of luck when it comes to earning interest on your escrow money.
How Escrow Works to Actually Pay Your Property Taxes & Homeowners Insurance
The process for how your lender uses your escrowed funds to pay your tax and insurance bills is kickstarted when they first calculate your monthly payment.They do this by estimating your property taxes and adding that number to your homeowners insurance premium, then dividing the total by 12.
After calculating what your monthly escrow payment needs to be, they add it into your monthly mortgage payment. Then, when you send your payment each month, they separate out the escrow portion and deposit it into your escrow account.
The third step occurs when your lender receives your property tax or homeowners insurance bills. This happens once or twice a year for property taxes in most counties and typically just once a year for your homeowners insurance premium.
After receiving your bill, your lender may choose to pay it before the due date, if there is an early payment discount. Otherwise, they'll simply arrange for the payment to come out of your escrow account closer to the due date.
Still Have Questions about Escrow?
Now that we've covered all the basics for the question "What is escrow?," we hope you have the confidence to move forward through the VA loan process. If you do have any questions about escrow or any other topic, we're happy to answer them when you call us at (866) 569-8272.