Most people assume that the amount they send off to the lender each month covers only what they borrowed plus the interest. But your monthly payments actually go toward a variety of purposes, including taxes and insurance. There is a part that goes toward your outstanding balance, another part goes toward your accrued interest, and the rest, handled by an escrow company, goes toward insurance premiums and tax payments. When making your payment, it is important to understand the difference between principal and escrow.
When you pay toward the principal on your mortgage, you are paying toward the original debt. When you pay toward escrow, you are setting aside funds to pay future interest, homeowners insurance and property taxes.
Many mortgage companies include payments to the escrow payment with your mortgage. For lenders that bill separately, you may have the option to put any money over the amount of your payment on either your escrow or the mortgage principal. It is up to you what you pay first, but make sure you know the facts before you decide.
How an Escrow Account Works
Escrow accounts are a part of the mortgage process homebuyers typically cannot avoid. With mortgages, home buyers typically pay a little extra into an escrow account every month, along with their home loan payments. They will divide your annual payment for these items by 12 and add that amount to your monthly mortgage payment. The funds are held by the lender until those payments become due.
While a mortgage holder (most typically a bank) collects the principal and interest payments each month, they also can collect homeowner’s insurance payments and property taxes. They will then pay those bills when they come due. They do this because when you borrow money from a lender to finance your home purchase, the property becomes the collateral for your loan. Your lender needs to know that the property is adequately insured so that it can be repaired or replaced if damaged. Likewise, they want to prevent a tax lien being placed on the property if you neglect to pay taxes.
Understanding the Loan Principal
The principal of your mortgage is the actual loan amount. Much of what you pay for the first several years is interest. If you make a payment that is over what you owe for the month, you can apply the extra to the principal amount. This lowers the amount you owe, which will lessen the amount of interest you are required to pay over the lifetime of your mortgage. Paying a little extra each month and directing it toward the principal can significantly shorten the length of your loan if you maintain the higher payments.
Paying to the Principal
Unlike other types of loans, the principal on your mortgage is actually paid in arrears and after the interest on your mortgage has accrued. When you pay to a mortgage’s principal, you are paying toward the outstanding balance of the loan. Mortgage balances are divided into two: the mortgage itself and its associated interest. When a home owner pays into a mortgage, a part of the payment goes toward the accrued interest on the account while the rest goes toward the mortgage’s principal.
This lowers the principal, and any interest accrued each month will be lower as long as your interest rate has not changed. This is because your interest rate is always a percentage of your outstanding principal.
Escrow refers to a third-party service that is part of every home purchase. When a buyer and seller initially arrive at a purchase agreement, they select a neutral third party to act as the escrow agent. The escrow agent collects a deposit from the buyer that is equal to a small percentage of the sale price. This deposit is known as “earnest money”. In exchange, the seller takes the property listing off the market. Until the final exchange is completed, both the seller’s property and the buyer’s deposit are said to be in escrow.
Paying to Escrow
Escrow accounts have two advantages. The first is that they allow the account holder to budget payments for the future instead of paying one lump sum at a future date. It is easier paying $100 every month instead of $1,200 at the end of the year. The second advantage is that, as a result of the budgeting that arises from escrow, mortgages become cheaper because the lender knows that the borrower will be more reliable with his payments.
Remember, your escrow account should be sufficient in covering your homeowner’s insurance and property taxes. If you are short, you will have the option to pay a lump sum to recover your escrow balance. Moreover, it is possible that you will get a refund on your escrow balance shortly after paying off your loan.
What is Included in Escrow?
Your escrow account consists of additional charges and fees. You can find the terms of these charges and fees in your mortgage statement. Below, we will detail what your escrow account is made up of and how it appears on your statement.
- Property Taxes
Escrow accounts are set up to collect property tax and homeowners insurance payments each month. When your insurance or property tax bill comes due, the lender uses the escrow funds to pay them. That way, you do not have to keep up with the payment deadlines and you’re not forced to shell out hundreds or thousands of dollars all at once to cover your taxes or keep your insurance current. Because failure to pay property taxes can result in a tax lien or foreclosure, some lenders require borrowers to maintain an escrow account to ensure that the payments are being made on time.
Your lender must work directly with the county tax collector to obtain the information on your property taxes. The county sends the tax bill to the lender for review. The lender then makes a payment to the county using the money from your escrow account. You should also receive a copy of your tax bill for your records; however, you don’t need to pay your tax collector directly.
- Homeowners Insurance
Your mortgage lender might also require an escrow account as part of the terms of your mortgage. In this case, the escrow account holds funds for property taxes and homeowner’s insurance. Lenders will pay your home-related taxes and insurance out of this amount to ensure that your home is not under-insured and that all taxes are paid. Your lender will take a month’s worth of your annual mortgage payment each month to continue coverage with homeowners insurance. Most insurance companies that offer homeowners insurance are usually paid twice a year. This comes out of your escrow account.
- Mortgage Insurance
Your mortgage insurance can vary depending on which program you chose in taking out a loan and the amount of your initial down payment. Mortgage insurance is necessary, as it protects your mortgage lender from losing out on their investment in the event that you default on your loan.
Your mortgage lender will need to get copies of your insurance and tax bills so they will know what to pay out of your escrow account. Never pay your insurance agent directly for things related to homeowners insurance, property taxes, or mortgage insurance.
Which Is More Important?
Both the principal and your escrow account are important. It is a good idea to pay money into your escrow account each month, but if you want to pay down your mortgage, you will need to pay extra money on your principal. The more you pay on the principal, the faster your loan will be paid off. Take the time to consider which one is more beneficial, and then make your payments accordingly.
There are benefits to paying extra on both accounts. Padding your escrow account is a good idea if you have an adjustable-rate mortgage that will allow your interest rate to go up. On the other hand, paying on your principal will pay off your loan much quicker and build equity in your home. Both have advantages. It is up to you to determine which one best suits your needs and then pay accordingly.
What Happens at Citrus Heritage Escrow?
Your escrow officer follows instructions on your contract, coordinates deadlines, and gathers all necessary paperwork. For example, written requests for payoff information (called “demands”) are sent to the Seller’s mortgage company and any other lien holders.
During the escrow period, the title company coordinates with Citrus Heritage Escrow and begins researching and examining all historical records pertaining to the subject property. Barring any unusual circumstances, a commitment for title insurance is issued, indicating a clear title or listing any items which must be cleared prior to closing. The commitment is sent to you for review.
When choosing an escrow company there can be many important factors to evaluate. Fees, location, staff and even recommendations from friends and colleagues are all things to consider. With Citrus Heritage Escrow by your side, you can rest assured that when you receive your settlement check, you’ve gained the maximum benefit from your home sale or purchase.
Call us today with any questions or concerns. Our professional Escrow Agents will help you through this exciting yet confusing process. (951) 335-7200