Mortgage lenders require borrowers to maintain an escrow account to ensure timely payment of homeowner's insurance and real estate taxes. The homeowner makes monthly payments to the account and the lender makes payments as the insurance and taxes become due. Escrow analysis is a means of determining, on an annual basis, whether the borrower is paying too much or too little so an adjustment can be made to the monthly payment.
Establishment of an Escrow Account
An escrow account is established at the real estate closing when the homebuyer becomes the owner of the property. A lender can require up to two months payments of taxes and insurance. The annual cost of homeowner's insurance and real estate taxes is calculated and then divided by twelve to determine the monthly cost. If the borrower is required to maintain flood insurance, that amount would also be calculated. The borrower then pays two months which becomes the initial balance in the escrow account, sometimes known as the "cushion."
RESPA Requirements for an Escrow Account
RESPA, the Real Estate Settlement Procedures Account, is a federal law that regulates escrow accounts. It doesn't require lenders to set up an escrow account for borrowers, but it does set rules when an account is established. RESPA mandates an initial analysis when the account is established and an annual escrow analysis thereafter. The key feature of RESPA is the requirement that a lender cannot require more than two months payments, above and beyond what is necessary to pay the taxes and insurance, as a cushion.
Escrow Analysis and Calculations
The annual escrow analysis is a calculation required under RESPA that determines whether the account is in balance, the borrower needs to pay money to make up a shortage or the lender has collected too much money and the borrower is entitled to a refund. The first annual analysis of an escrow account starts with the beginning balance, the so-called cushion paid at closing, and then adjusts the balance each month by adding the monthly payment and subtracting any disbursements.
Overage and Shortages of Escrow Accounts
An overage in the escrow account requires the lender to issue a check to the borrower. This would occur if there was a tax cut or the borrower found a less expensive homeowner's insurance policy. More likely is a shortage caused by an increase in taxes or the price of the homeowner's insurance policy. A borrower who receives a letter indicating either an overage or shortage should carefully examine the escrow analysis to verify it was done correctly.