Despite how it sounds, your mortgage payment doesn’t just go toward repaying your mortgage loan.
In fact, there are actually four distinct parts to a mortgage payment: principal, interest, taxes, and insurance — also called “PITI.” The first two (principal and interest) go to your lender to pay off your balance and the interest you owe for borrowing the money. But the last two (taxes and insurance) go into an escrow account, which is a type of bank account your loan servicer uses when certain bills are due throughout the year.
Sometimes, though, that account comes up short — and when it does, you’ll see some changes to your mortgage payment.
An escrow account (sometimes called an impound account) is a bank account your mortgage servicer uses to hold money designated for your property taxes, homeowners insurance premiums, and mortgage insurance.
Here’s how it works: You make your mortgage payment, and the principal and interest portions go straight to your lender, reducing your loan balance. The other two parts — the taxes and insurance portions — are deposited into an escrow account. Then, when your annual property taxes come due or you renew your homeowners insurance, the servicer takes money from that account to settle the bill.
Escrow accounts are commonly used, but they aren’t required for every mortgage borrower. Whether you need one will depend on the loan type, your mortgage lender, and your state’s laws.
If you qualify for an escrow waiver, you can pay for your insurance and property taxes on your own in lieu of using an escrow account. To apply for a waiver, you’ll likely have to submit documentation such as your mortgage payment history, proof of homeowners insurance, and your credit report to your lender.
Learn more: How does private mortgage insurance (PMI) work?
Your mortgage lender will conduct an annual escrow analysis to determine how much you need to put into your escrow account with each payment.
They’ll look at your escrow history, what you owed in taxes and insurance premiums in the previous year, and a forecast of what those expenses will be in the upcoming year. The servicer will then divide those forecast costs over 12 months and add the new amount to your monthly principal and interest payments.
Unfortunately, neither homeowners insurance premiums nor property taxes are set in stone, so sometimes, servicers get it wrong. In these cases, you don’t end up stowing enough money in escrow to cover those tax and insurance bills. This would be considered an escrow shortage.
Here’s an example: Let’s say $500 of your monthly payment goes into your escrow account each month. So, by the end of the year, you have $6,000 stored away. Your property tax bill comes in at $4,500, and your servicer uses your escrow account to pay the bill, leaving you with $1,500. Shortly after, your home insurance premium comes due, but it’s increased over the last year — now coming in at $2,000. This would leave you with a shortage amount of $500.
Read more: How much does homeowners insurance cost?
When there’s an escrow shortage, your servicer will usually make up for it by increasing how much you put into your escrow account each month. This, subsequently, increases your monthly mortgage payment.
If you don’t want the higher payment, mortgage lenders may also offer you the option to cover the shortage with a one-time payment. As long as this is paid before your next escrow analysis, the shortage won’t be added to your monthly payments for the coming year.
Sometimes, the opposite happens, and you end up having money left in your escrow account after your property taxes and home insurance premiums have been paid. This is called an escrow surplus.
When this happens, your loan servicer will typically send you a check for the surplus amount. If it’s only a small surplus, the servicer may keep it in your escrow account as a buffer. (For example, Freedom Mortgage only sends you a check for surpluses of $50 or more).
Yes, you should pay an escrow shortage. You typically have two options for paying off an escrow shortage: make a single, lump-sum payment or spread the shortage across all 12 of next year’s mortgage payments. The right choice depends on how much you have saved up and whether you can handle a higher monthly payment.
Loan servicers try to forecast your future insurance premiums and property taxes as best they can, but they won’t always get it right. If your premium or tax bill comes in higher than expected, you will need to cover the shortage — typically through higher monthly payments. In some cases, your lender may let you pay off the amount with one lump-sum escrow shortage payment if you don’t want your monthly costs to increase.
Your escrow requirements likely went up because your property taxes have increased, insurance premiums are rising in your area, or both. You could also be paying more due to an escrow shortage in the previous year.
If you have a lot left over in your escrow account after your annual property taxes and homeowners insurance premiums have been paid, your mortgage servicer may write you a check for the remaining amount. It might only do this if your surplus exceeds a small amount, such as $50.
Laura Grace Tarpley edited this article.
