Escrow can be a confusing topic. It is something most people have heard of and have a vague sense of what it is. Escrow is when a third party is granted legal power to hold money or assets until special conditions are met. The purpose of escrow is to reduce the risk for all parties involved in the transaction.
The main reason that people (and mortgage lenders) use escrow is that it adds a layer of security to the home-buying and mortgage processes. Although escrow is used slightly differently at the home-buying stage than it is during the life of a home loan, the principle of holding funds remains the same.
Becoming a homeowner comes with a fair share of big financial decisions. Sometimes, opting to refinance your home after some time is the best way to make sure you are getting the most favorable terms on your mortgage.
But what happens to escrow once you refinance your mortgage?
What Does It Mean To Refinance a House?
Refinancing the mortgage on your house means you are essentially trading in your current mortgage for a newer one – often with a new principal and a different interest rate. Your lender then uses the newer mortgage to pay off the old one, so you’re left with just one loan and one monthly payment.
There are a few reasons people refinance their homes. You can use a cash-out refinance to make use of your home’s equity or look into a rate and term refinance to get a better interest rate and/or lower monthly payment. A refinance could also be used to remove another person from the mortgage, which often happens in the case of divorce. You can also add someone to the mortgage.
When Should You Refinance a Mortgage?
A mortgage refinance provides you with a new mortgage that pays off and replaces your old one. Refinancing can help you by lowering your monthly mortgage payment, improving your overall loan terms or allowing you to tap your home equity.
Figuring out when to refinance a mortgage can be tricky, but the key is this: You should do it when you know you will receive a financial benefit.
Some common reasons you might opt for refinancing are:
- You can get a lower interest rate
- You want to shorten your loan term
- Your credit score has gone up
- Your DTI ration has gone down
- You want to tap into your home’s equity
What Happens to Escrow When You Refinance?
When you refinance your mortgage, your new lender will issue you a new loan that will completely cover your existing loan. While you can expect this new loan to pay off the principal amount of your current loan, you might not know that you will be responsible for fully funding the escrow account for your new loan. Depending on the timing of when your taxes and insurance bills are due and when in the year you close on your loan, this could be several months’ worth of escrow payments due at closing.
Unlike your actual mortgage, where your new loan will generally pay off your old loan completely, you likely cannot use the money in your existing escrow account to fund your new escrow account. Instead, you’ll generally have to fully fund your new escrow account at closing, increasing the amount of money you need to bring to closing. Then, you’ll receive a check from your old escrow account a few weeks or months later.
If you refinance your mortgage but stick with your current lender, you will still have to fund your escrow account and then get a check back a while later. It may be possible for your lender to transfer funds from one escrow account to the other—check with your mortgage officer to see what options might be available.
Using Old Escrow Funds
Because the funds will be sent to you at a later date, it is usually impossible to use held escrow funds from a previous loan to apply it toward your new escrow account on the refinanced loan. It will cost more money out of your pocket to fund your escrow account with your refinance loan, and depending on the time of year that you are refinancing, the lender may require a substantial amount in taxes to be pre-paid into escrow.
In a refinance, a homeowner replaces his or her current mortgage with a new mortgage. The new mortgage often comes with more favorable terms to the borrower than those of the current mortgage. When the new mortgage has been finalized with a new lender, that lender will then make use of the escrow process to disburse money to the old lender to cover the old mortgage.
Establishing Reserves
The lender determines the minimum amount the escrow holder must collect upon refinance closing. To calculate this figure, the lender adds the homeowner’s insurance premium and the annual tax bill amounts. The sum divided by 12 is the monthly installment the borrower pays into the escrow account. At closing, the lender instructs the escrow agent to collect a specified number of installment payments to establish the reserves. The lender draws from these reserves when the first insurance premium and tax payments become due.
Do Escrow Payments Increase When You Refinance?
Refinancing a home can lower monthly mortgage payments or reduce interest rates, which could save you tens of thousands of dollars over the course of a loan. But some lenders require you to enter escrow as part of the transaction.
In most cases, refinancing is only available after a homeowner has paid off a certain percentage of their mortgage. With more equity in your home, you can acquire a lower sum of money and distribute it over more years, which lowers your payments.
The major difference with an escrow when you refinance comes down to who you’re taking a new loan from. If it’s the same lender, your escrow account may never change. But if it’s not, you’ll have to close the old escrow account and start a new one.
A Final Word
Your home purchase is one of the biggest investments you will make. Over the past century of buying and selling real estate in the United States, many processes have been put into place to protect the home-buying process, as well as your homeownership rights. The escrow account is an essential tool that offers protection to everyone in the process.
Whether you are the buyer, seller, lender, or borrower, you want the assurance that no funds or property will change hands until ALL of the instructions in the transaction have been followed. Your escrow company is what safeguards your funds and documents while those funds and documents are in their possession.